The Second Moment Matters! Cross-Sectional Dispersion of Firm Valuations and Expected Stock Returns

55 Pages Posted: 3 Apr 2007 Last revised: 2 Aug 2013

See all articles by Danling Jiang

Danling Jiang

College of Business, Stony Brook University

Date Written: July 24, 2013

Abstract

Behavioral theories predict that firm valuation dispersion in the cross section (“dispersion”) measures aggregate overpricing caused by investor overconfidence and should be negatively related to expected aggregate returns. This paper develops and tests these hypotheses. Consistent with the model predictions, I find that measures of dispersion are positively related to aggregate valuations, trading volume, idiosyncratic volatility, past market returns, and current and future investor sentiment indexes. Dispersion is a strong negative predictor of subsequent shortand long-term market excess returns. Market beta is positively related to stock returns when the beginning-of-period dispersion is low and this relationship reverses when initial dispersion is high. A simple forecast model based on dispersion significantly outperforms a naive model based on historical equity premium in out-of-sample tests and the predictability is stronger in economic downturns.

Keywords: Return Predictability, Dispersion, Overconfidence, Sentiment, Business Cycle

JEL Classification: G12, G14

Suggested Citation

Jiang, Danling, The Second Moment Matters! Cross-Sectional Dispersion of Firm Valuations and Expected Stock Returns (July 24, 2013). Journal of Banking and Finance, 2013, 37(10), 3974-3992, Available at SSRN: https://ssrn.com/abstract=976675 or http://dx.doi.org/10.2139/ssrn.976675

Danling Jiang (Contact Author)

College of Business, Stony Brook University ( email )

306 Harriman Hall
Stony Brook, NY 11794
United States

HOME PAGE: http://sites.google.com/site/danlingjiang

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