Interpreting Mean Reversion in Stock Returns

This research attempts to distinguish between two competing economic explanations of mean reversion in stock returns: 1) mispricing in irrational markets versus 2) predictable time variation in security risk premia. Excess portfolio returns are decomposed into 'explained' and 'unexplained' components using the CAPM. If one restricts the market risk premium to be constant over time, then mean reversion could be interpreted as a manifestation of mispricing in irrational markets. But changing the assumption about the time-series behavior of the market risk premium dramatically alters the test results. If one permits the conditional market risk premium to vary and to differ from the unconditional market risk premium, then mean reversion in stock returns is consistent with rational pricing in the framework of the CAPM. This suggests one need not abandon models based on rationality to explain this puzzling return behavior