Which Expectation?

75 Pages Posted: 30 Jan 2022 Last revised: 2 Jan 2024

See all articles by Juhani T. Linnainmaa

Juhani T. Linnainmaa

Dartmouth College - Tuck School of Business; National Bureau of Economic Research (NBER); Kepos Capital

Yingguang Zhang

Peking University - Department of Finance, Guanghua School of Management

Guofu Zhou

Washington University in St. Louis - John M. Olin Business School

Date Written: December 29, 2023

Abstract

We test a theory of two expectations in asset pricing: investors separately form beliefs on cash flow level and cash flow growth when valuing assets. Using 123 anomalies and analysts’ earnings term structure forecasts, we find strong evidence for the separability of the two beliefs. Forecast errors in cash flow level and cash flow growth are uncorrelated. Anomaly portfolios typically manifest biases in one belief or the other but not both. Anomalies with large (small) alphas often have the two biases amplifying (offsetting) each other. The first two principal components of anomaly returns are essentially a growth bias factor and a level bias factor. The two biases explain about 50\% of the anomaly portfolios' cross-sectional deviation from the CAPM. Level bias generates large initial alpha and growth bias generates persistent alpha. We also provide an explanation for the recent alpha decay with analysts’ improved forecast accuracy.

Keywords: Earnings expectation, stock return, anomaly, market efficiency

JEL Classification: G11, G12

Suggested Citation

Linnainmaa, Juhani T. and Zhang, Yingguang and Zhou, Guofu, Which Expectation? (December 29, 2023). Available at SSRN: https://ssrn.com/abstract=4019170 or http://dx.doi.org/10.2139/ssrn.4019170

Juhani T. Linnainmaa

Dartmouth College - Tuck School of Business ( email )

Hanover, NH 03755
United States

HOME PAGE: http://www.tuck.dartmouth.edu/faculty/faculty-directory/juhani-linnainmaa

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Kepos Capital ( email )

620 Eighth Avenue
New York, NY 10018
United States

Yingguang Zhang (Contact Author)

Peking University - Department of Finance, Guanghua School of Management ( email )

Beijing, Beijing 100871
China

Guofu Zhou

Washington University in St. Louis - John M. Olin Business School ( email )

Washington University
Campus Box 1133
St. Louis, MO 63130-4899
United States
314-935-6384 (Phone)
314-658-6359 (Fax)

HOME PAGE: http://apps.olin.wustl.edu/faculty/zhou/

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