Mispricing and the Cross-Section of Stock Returns

Abstract

We provide evidence that stocks with low mispricing substantially outperform otherwise similar stocks. Specifically, the long-short mispricing strategy generates a statistically and economically significant return of 11.75 percent per annum over the period of July 1981 to June 2005. The mispricing measure is estimated based on Campbell and Shiller (1988) and it captures investor overreaction to growth. The mispricing strategy subsumes various contrarian strategies based on accounting fundamental-to-price ratios, because the model-based mispricing measure is more effective in capturing mispricing opportunities. The superior performance of the mispricing strategy cannot be explained by risk nor firm characteristics of value, size, and momentum. In addition, the return predictability of the price-to-dividend (P/D) ratio is due to mispricing rather than time-varying risk premium. Thus, market inefficiency is present even in the most efficient set of the largest, dividend-paying stocks.

Keywords: model-based mispricing, mispricing strategy, contrarian strategy, return predictability, price-dividend ratio, overreaction to growth, cross-section of stock returns

JEL Classification: G11, G12, G14