Market Belief Risk and the Cross-Section of Stock Returns

Abstract

This paper studies the effect of market belief risk on the cross-section of stock returns. Using actual and analyst EPS forecast data, we construct the market belief as the cross-sectional average of individual beliefs for all sample stocks, with individual belief defined as the mean analyst EPS forecast minus the one derived from the Brown and Roze (1979) EPS model. We observe that a portfolio that is long in stocks with the highest sensitivities and short in stocks with the lowest sensitivities to innovations in market belief earns an average yearly return of 5.4%. This positive relationship between market belief risk and stock returns persists after accounting for traditional risk factors and is particularly strong for large-cap stocks. These findings are robust when considering alternative specications of market belief risk. Finally, we find that stocks' exposure to market belief risk increases with their market beta, volatility, turnover rate, and their sale-to-asset ratio and decreases with their size, momentum, and analyst coverage.