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Profitability Shocks and the Size EFfect in the Cross-Section of Expected Stock Return

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  • Hou, Kewei

    (Ohio State University)

  • van Dijk, Mathijs A.

    (Erasmus University Rotterdam)

Abstract

Recent studies report that the size effect in the cross-section of U.S. stock returns has disappeared after the early 1980s. We examine whether the disappearance of the size effect in realized returns can be attributed to unexpected shocks to the profitability of small and big firms. We show that small firms experience large negative profitability shocks after the early 1980s, while big firms experience large positive shocks. As a result, realized returns of small and big firms over this period differ substantially from expected returns. After adjusting for the price impact of profitability shocks, we find that there still is a robust size effect in expected returns. Our results suggest that in-sample cash flow shocks can significantly affect inferences about predictability in the cross-section of stock returns.

Suggested Citation

  • Hou, Kewei & van Dijk, Mathijs A., 2010. "Profitability Shocks and the Size EFfect in the Cross-Section of Expected Stock Return," Working Paper Series 2010-1, Ohio State University, Charles A. Dice Center for Research in Financial Economics.
    • Handle: RePEc:ecl:ohidic:2010-1
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    File URL: http://www.cob.ohio-state.edu/fin/dice/papers/2010/2010-1.pdf
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    Cited by:

    1. Hou, Kewei & van Dijk, Mathijs A. & Zhang, Yinglei, 2012. "The implied cost of capital: A new approach," Journal of Accounting and Economics, Elsevier, vol. 53(3), pages 504-526.
    2. Joel Vanden, 2015. "Noisy information and the size effect in stock returns," Annals of Finance, Springer, vol. 11(1), pages 77-107, February.
    3. Shu, Yan & Broadstock, David C. & Xu, Bing, 2013. "The heterogeneous impact of macroeconomic information on firms' earnings forecasts," The British Accounting Review, Elsevier, vol. 45(4), pages 311-325.

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