Forecasting Cross-Section Stock Returns using Theoretical Prices Estimated from an Econometric Model

We contribute to the debate over whether forecastable stock returns reflect an unexploited profit opportunity or rationally reflect risk differentials. We test whether agents could earn excess returns by selecting stocks which have a low market price compared to an estimate of the fundamental value obtained from an econometric model. The criterion for stock picking is one which could actually have been implemented by agents operating in real time. We show that statistically significant, and quantitatively substantial excess returns are delivered by portfolios of stocks which are cheap relative to our estimate of fundamental value. There is no evidence that the underpriced stocks are relatively risky and hence the excess returns cannot easily be interpreted as an equilibrium compensation for risk.