Which Expectation? Toward a Unified Framework of Expectations-Based Asset Pricing

Abstract

I propose an expectations-based theory that can account for many cross-sectional anomalies. In the model, investors have sticky expectations on cash flow levels, and this stickiness interacts with growth extrapolations to generate novel predictions. A new measure derived from the model forecasts contrarian profits, explains common factor premia, and predicts the timing of price momentum and reversal. The resultant trading strategies yield abnormal returns of 7% to 12% per year. Simulation and empirical results using 69 anomalies strongly support the model's additional predictions: (1) mispricing associated with growth (level) forecast errors are persistent (transient), and (2) ex ante anomaly variables reliably predict the ex post term structure of analyst forecast errors.

Keywords: Asset pricing, stock returns, expectation, extrapolation, momentum, reversal, mispricing

JEL Classification: G11, G12