Predictability and the Cross-Section of Expected Returns: A Challenge for Asset Pricing Models

Christian Schlag (), Michael Semenischev () and Julian Thimme ()
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Christian Schlag: Department of Finance, Goethe University Frankfurt, 60323 Frankfurt, Germany
Michael Semenischev: Leibniz Institute for Financial Research SAFE, 60323 Frankfurt, Germany; d-fine GmbH, 60313 Frankfurt, Germany
Julian Thimme: Institute for Finance, Karlsruhe Institute of Technology, 76131 Karlsruhe, Germany

Management Science, 2021, vol. 67, issue 12, 7932-7950

Abstract: Many modern macro finance models imply that excess returns on arbitrary assets are predictable via the price-dividend ratio and the variance risk premium of the aggregate stock market. We propose a simple empirical test for the ability of such a model to explain the cross-section of expected returns by sorting stocks based on the sensitivity of expected returns to these quantities. Models with only one uncertainty-related state variable, like the habit model or the long-run risks model, cannot pass this test. However, even extensions with more state variables mostly fail. We derive conditions under which models would be able to produce expected return patterns in line with the data and discuss various examples.

Keywords: asset pricing; cross-section of stock returns; predictability (search for similar items in EconPapers)
Date: 2021
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Persistent link: https://EconPapers.repec.org/RePEc:inm:ormnsc:v:67:y:2021:i:12:p:7932-7950

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