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The second moment matters! Cross-sectional dispersion of firm valuations and expected returns

Danling Jiang

Journal of Banking & Finance, 2013, vol. 37, issue 10, 3974-3992

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 short- and 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; Investor sentiment; Valuation ratios; Business cycle (search for similar items in EconPapers)
JEL-codes: G12 G14 (search for similar items in EconPapers)
Date: 2013
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Handle: RePEc:eee:jbfina:v:37:y:2013:i:10:p:3974-3992