Persistent Expected Returns and the Cross-Section of Stock Returns

Abstract

Even though stock returns are not highly autocorrelated, their persistent expected returns, even if they are small, impact the cross-sectional estimations of asset pricing models and tests. We find that estimations that do not utilize conditioning information about the nature of persistent expected returns efficiently are biased. The bias is more severe for assets with larger and more persistent expected returns, for larger cross-section of assets and in shorter time-series. Our results, further, show that the estimation of the asset pricing models and tests that uses conditional information efficiently provides more accurate results in the presence of persistent expected returns.

Keywords: persistent expected returns, stochastic discount factor bounds, asset pricing tests, conditioning information

JEL Classification: G11, G12