Which stock return predictors reflect mispricing? *

Abstract

A large number of variables have been found to predict the cross-section of stock returns. Return predictability can be driven by risk or mispricing, and the nature of most return predictors remains an open question. I use analysts' earnings forecasts to determine if a return predictor is linked to mispricing. I find that at least 40% of return predictors from a dataset of 172 significant predictors are related to mispricing, including the momentum predictor from the Carhart four-factor and the profitability and investment predictors from the Fama-French five-factor model. I further study whether the mispricing predictors' abnormal returns capture the divergence of prices from the fundamental value (build-up predictors) or their convergence back to the fundamental value (resolution predictors). Build-up predictors are less common than resolution predictors, but they do exist, implying that trading on certain return predictors can exacerbate rather than eliminate mispricing. Momentum is related both to the build-up and the resolution of mispricing.

Keywords: Anomalies, Mispricing, Expectations, Return Predictability

JEL Classification: G02, G12, G14