What firm/asset/market conditions signal mispricing? In the November 2017 version of their paper entitled “Bonds, Stocks, and Sources of Mispricing”, Doron Avramov, Tarun Chordia, Gergana Jostova and Alexander Philipov investigate drivers of U.S. corporate stock and bond mispricing based on interactions among asset prices, financial distress of associated firms and investor sentiment. They measure financial distress via Standard & Poor’s long term issuer credit rating downgrades. They measure investor sentiment primarily with the multi-input Baker-Wurgler Sentiment Index, but they also consider the University of Michigan Consumer Sentiment index and the Consumer Confidence Index. They each month measure asset mispricing by:
- Ranking firms into tenths (deciles) based on each of 12 anomalies: price momentum, earnings momentum, idiosyncratic volatility, analyst forecast dispersion, asset growth, investments, net operating assets, accruals, gross profitability, return on assets and two measures of net share issuance.
- Computing for each firm the equally weighted average of its anomaly rankings, such that a high (low) average ranking indicates the firms’s assets are relatively overpriced (underpriced).
Using monthly firm, stock and bond data for a sample of U.S. firms with sufficient data and investor sentiment during January 1986 through December 2016, they find that:
- Data requirements translate to a sample of relatively large and liquid firms with a wide range of credit ratings.
- Within the sample, the fifth of firms with the highest credit risks tend to be:
- Smaller, more volatile, less liquid, higher book-to-market firms, with lower institutional ownership and thinner coverage by analysts with higher earnings forecast dispersion.
- On the short side of anomaly portfolios.
- Overpriced, with stocks that subsequently earn lower returns.
- Within the sample:
- The equally weighted tenth of stocks that are most overpriced (underpriced) generates average gross monthly return 0.32% (1.28%). The effect concentrates in non-investment grade firms, for which the difference in average gross monthly stock returns between extreme overpriced and underpriced deciles is -1.89%.
- The equally weighted tenth of bonds that are most overpriced (underpriced) generates average gross monthly return 0.35% (0.66%). This effect also concentrates in non-investment grade firms, for which the difference in average gross monthly bond returns between extreme overpriced and underpriced deciles is -0.62%.
- For underpriced firms, both stocks and bonds of high credit risk firms outperform those of low credit risk firms.
- Among the third of firms with the highest credit risks:
- The difference in average gross monthly returns between the most overpriced and underpriced stocks is -0.96%. This mispricing concentrates around credit rating downgrades and is absent for firms with the lowest credit risks.
- The difference in average gross monthly returns between the most overpriced and underpriced bonds is -0.27%. This mispricing is also absent for firms with the lowest credit risks.
- Gross multi-factor alphas are comparable to raw average returns.
- Overpricing of high credit risk firms concentrates during times when investor sentiment is high. Following high sentiment, the difference in average gross monthly returns between the equally weighted most overpriced and underpriced stocks (bonds) is -1.31% (-0.34%). There is no overpricing of such stocks or bonds when investor sentiment is low.
- Cross-sectional stock and bond return anomalies emerge as overpricing of assets of high credit risk firms corrects as investor sentiment falls.
- Findings are generally robust to using University of Michigan Consumer Sentiment Index or the Consumer Confidence Index to represent investor sentiment.
In summary, evidence indicates that overpricing of stocks and bonds emerges only during times of high investor sentiment, only among stocks and bonds of high credit risk firms and only around credit downgrades.
Cautions regarding findings include:
- Results are gross, not net.
- Costs of monthly reformation would reduce returns for all portfolios.
- Findings indicate that correction of overpricing would take place largely on the short sides of portfolios constructed to exploit associated anomalies (as overpriced distressed stocks revert when investor sentiment declines). Shorting may be relatively costly or infeasible for such stocks.
- Required firm and asset data collection/processing and portfolio management is beyond the reach of most investors, who would bear fees for delegating to a fund manager.
For closely related research see “Credit Ratings and Stock Return Anomalies” and “Interaction of Investor Sentiment and Stock Return Anomalies”.
