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Two essays on explaining cross-sectional anomalies using return decomposition

Price and earnings momentum

How does the market read information conveyed by accruals?

Authors Mao, Qinghao
Issue Date 2011
Summary This thesis studies two important asset pricing anomalies using a unified framework of return decomposition. Based on analyst earnings forecasts and residual income models, stock returns are decomposed into the expected return component, cash flow news and discount rate news. Chapter 1 tests the rational and behavioral explanations for price and earnings momentum. The results demonstrate that momentum profits do not come from the expected return component. Instead, momentum profits are mainly attributed to the large positive cash flow news and are partially offset by the negative discount rate news. The cash flow news is quite persistent before and after portfolio formation. The time-series dynamics in the discount rate news explain why the ex-ante expected return does not account for momentum returns. Compared with price momentum, earnings momentum does not sort by past discount rate news and does not display a long-term reversal. Overall, the empirical evidence based on return decomposition tends to support the behavioral explanation that the market incorporates cash flow information too slowly, which drives momentum returns. Chapter 2 studies the return predictability of accruals by exploring how fundamental information is incorporated into stock prices in the time series. Evidences show that the underperformance of high accruals stocks mainly comes from the underperformance in the cash flow news component with the effect being stronger for low accruals quality stocks. In addition, high discretionary accruals stocks experience lower total returns and cash flow news both before and after portfolio formation. No such pattern is observed for stock portfolios based on nondiscretionary accruals. At the aggregate level, innovations in aggregate accruals are negatively associated with contemporaneous returns through the discount rate news. Higher aggregate accruals predict higher future market returns due to both the expected return component and the discount rate news component. Overall, the results lend supports to the earnings fixation hypothesis, agency theory of earnings management, and Hirshleifer, Hou and Teoh's (2009) conjecture that aggregate accruals contain information about market discount rates.
Note Thesis (Ph.D.)--Hong Kong University of Science and Technology, 2011
Language English
Format Thesis
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