Expected Return and Asset Pricing

Asset pricing models predict relations between assets’ expected rates of return and their risks or behavioral attributes. However, almost all tests of these models use realized return as a proxy for expected return. This paper extracts proxies for the market’s estimate of expected return using Value Line analysts forecasts (for approximately 2,900 stocks for 27 years), and tests the relation between these exante expected return estimates and factors proposed in the literature to explain them. Consistent with the predictions of the CAPM, we find that market beta is positively related to expected returns. As with tests that employ ex-post realized returns, we find that expected return is negatively related to the firm’s market value of equity. Contrary to the implication of Fama and French (1993) and others, we find that using the expectations of Value Line analysts low book-tomarket firms are not expected to earn higher returns than high book-to-market firms. We also find that prior one-year returns are negatively related to expected returns. Finally, we use an additional source of estimated expected return (based on sell-side analysts’ estimates) and find that the basic relation between expected returns and stocks’ characteristics are similar for both set of expectations. Expected Return and Asset Pricing Asset pricing models seek to establish the determinants of financial assets’ expected rates of return. Classic asset pricing models, such as Sharpe (1964), Lintner (1965), and Black (1972), predict that an asset’s expected return should be positively related to its systematic market risk. Based on Merton’s (1973) ICAPM, Fama and French ((1992), (1993)) explain their findings of higher returns for high book-to-market stocks and low capitalization stocks as a compensation for risk. That is, those stocks are expected to earn higher rates of return because they are riskier. These models imply that expected return and risk are positively related. While these models aim at explaining cross-sectional variation in expected returns, researchers have been forced to use realized return as a proxy for expected return. This necessary working assumption (due to the absence of data revealing market’s expectations of future outcomes) implies that tests of asset pricing models are conditioned on both the hypothesis of rational expectations in the sense that the average realization is a good proxy for expectation and that the asset pricing model describes the relation between expectations and asset pricing attributes. Using realized returns, it is difficult (if not impossible) to disentangle whether some of the results in the empirical literature are driven by the inadequacy of the rational expectations assumption or because expectations are not in line with those generated by the null asset pricing model. For example, should the finding of Fama and French ((1992), (1993)) and others that high book-to-market stocks exhibit higher realized return than low book-to-market stocks be interpreted as compensation for exposure to systematic risk? Or it is mispricing? In this paper we complement existing research by providing direct tests of the relation between ex-ante measures of expected return and several factors that have been shown to explain its cross-sectional variation, such as beta, book-to-market, market capitalization, and price momentum. By using an ex-ante measure of expected return we are able to avoid the identifying assumption that expected returns equal the average realized return.