The MAX effect: An exploration of risk and mispricing explanations

This paper studies the role that risk and mispricing play in the negative relation between extreme positive returns and future returns. We document a strong ‘MAX effect’ in Australian equities over 1991–2013 that is robust to risk adjustment, controlling for other influential stock characteristics and, importantly, manifests in a partition of the 500 largest stocks. While there is no evidence that MAX proxies for sensitivity to risk, the findings are highly consistent with a mispricing explanation. Adapting the recent methodological innovation of Stambaugh et al. (2015) to classify stocks by their degree of mispricing, we show that the MAX effect concentrates amongst the most-overpriced stocks but actually reverses amongst the most-underpriced stocks. Consistent with arbitrage asymmetry, the magnitude of the MAX effect amongst overpriced stocks exceeds that amongst underpriced stocks, leading to the overall negative relation that has been well documented.