Directional Information in Equity Returns

Abstract

We document the existence of sign predictability in equity returns. An investment strategy that buys stocks deemed most likely to have positive returns and sells stocks with the lowest probability of positive returns generates about 1% monthly alpha and is not explained by established asset pricing models. The proposed strategy has higher Sharpe ratios and exhibits fewer crashes than the renowned momentum strategy. We show that profits from exploiting directional information are driven by shifts in retail investors’ expectations after periods of excessive pessimism or optimism, rather than compensation for risk. We provide a simple model to motivate our findings.

Keywords: Sign predictability, biased expectations, mispricing, momentum, crashes

JEL Classification: G11, G12