Cross-Sectional Dispersion of Firm Valuations and Expected Stock Returns

Abstract

This paper develops two competing hypotheses for the relation between the cross-sectional standard deviation of logarithmic firm fundamental-to-price ratios (``dispersion'') and expected aggregate returns. In models with fully rational beliefs, greater dispersion indicates greater risk and higher expected aggregate returns. In models with investor overconfidence, greater dispersion indicates greater mispricing and lower expected aggregate returns. Consistent with the behavioral models, the results show that (1) measures of dispersion are negatively related to subsequent market excess returns, (2) this negative relation is more pronounced among riskier firms, and (3) dispersion is positively related to aggregate trading volume, idiosyncratic volatility, and investor sentiment, and increases after good past market performance