Factor Models with Drifting Prices

Abstract

This paper introduces a generalization of standard factor models where deviations of an asset price from its permanent component emerge as a predictor for returns. Intuitively, future expected returns are low (high) when asset prices are above (below) their fundamental value. We find support for this mechanism using a large set of anomalies and out-of-sample tests. We also discuss price deviations and return predictability within a diagnostic expectations framework. Moreover, our approach allows comparing different factor models in terms of their ability to track long-run portfolio returns. We conclude by studying the implications of our model for conditional asset pricing.

Keywords: Factor Models, Mispricing, Return Predictability, Diagnostic Expectations.

JEL Classification: C38, G12, G17.