Mispricing and the Cross-Section of Stock Returns

49 Pages Posted: 21 Mar 2007

See all articles by Carl R. Chen

Carl R. Chen

University of Dayton

Peter P. Lung

University of Dayton

F. Albert Wang

University of Dayton - School of Business Administration - Department of Economics and Finance

Date Written: November 27, 2006

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

Suggested Citation

Chen, Carl R. and Lung, Peter P. and Wang, Fukuo Albert, Mispricing and the Cross-Section of Stock Returns (November 27, 2006). Available at SSRN: https://ssrn.com/abstract=971863 or http://dx.doi.org/10.2139/ssrn.971863

Carl R. Chen

University of Dayton ( email )

300 College Park
Dayton, OH 45469-2251
United States
937-229-2418 (Phone)
937-229-2477 (Fax)

Peter P. Lung

University of Dayton ( email )

300 College Park
Dayton, OH 45469
United States

Fukuo Albert Wang (Contact Author)

University of Dayton - School of Business Administration - Department of Economics and Finance ( email )

300 College Park
Dayton, OH 45469
United States
937-229-3095 (Phone)

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