Asset Pricing with Price Levels
68 Pages Posted: 28 Dec 2019 Last revised: 7 May 2020
Date Written: November 18, 2019
We propose a novel way to study asset prices based on asset price distortions rather than abnormal returns. Our theoretical contribution is the new exact identity that expresses ex-ante price distortion in terms of subsequent abnormal returns. Unlike existing measures, our identity correctly reflects that not only the magnitude but also the time and state in which abnormal returns occur matter for ex-ante mispricing. Our identity also implies a simple measure of price level that summarizes the entire term structure of discount rates and a price-level regression that appropriately generalizes the conventional return regression to long horizons. Empirically, our price-level regressions reveal three important facts about price levels of stocks: (1) The CAPM does a relatively good job describing the cross-section of average price levels, despite its poor ability to explain short-horizon returns. (2) Positive (negative) short-horizon abnormal returns do tend to imply underpricing (overpricing), but momentum is an important exception. (3) Portfolios sorted on investment, beta, net equity issuance, and the interaction of value and quality are important price-level anomalies that both long-term buy-and-hold investors and researchers disciplining models from the price-level perspective should prioritize.
Keywords: price level, long-horizon returns, mispricing metric, stochastic discount factor, CAPM
JEL Classification: G12, G14, G32
Suggested Citation: Suggested Citation