The Market State, Mispricing and Asset Pricing Anomalies

Abstract

This paper examines the role of the market state in predicting asset pricing anomalies. We find that the sign, size, and significance of anomaly returns depend crucially on whether they follow a positive or negative market excess return. The predictive power of the negative market state is especially strong for portfolios sorted on an aggregate mispricing measure. We conjecture that these findings can be explained by the loosening of arbitrage capital for investors with short positions and the disposition effect for investors with long positions. Our hypothesis is supported by empirical evidence on short interest, liquidity and fund flows.

Keywords: Asset Pricing Anomalies, Market State, Mispricing, Idiosyncratic Volatility, Arbitrage Risk, Arbitrage Asymmetry, Disposition Effect

JEL Classification: G11,G12