Essays on stock returns

My dissertation lies in the area of empirical and theoretical asset pricing, with a focus on understanding the economic determinants of the time series and cross-sectional variation of stock returns.;The first chapter explores the relation between investment-specific shocks (i.e., technological innovations in equipment and software), firm investment, and momentum profits. Empirically, momentum profits comove positively with investment-specific shocks with a correlation coefficient of 0.32. An unconditional two-factor model, with investment-specific shocks and market excess returns as the risk factors, explains 90% of the average returns of momentum portfolios. Consistent with investment dynamics, I propose a rational explanation for momentum profits: Past winners are those who had good idiosyncratic productivity in the recent past; they initiate more investment, make greater investment commitments, and hence have a higher risk exposure to investment-specific shocks than past losers. A simple investment-based asset pricing model is developed to elaborate this story, with the key ingredients of investment commitment and investment-specific shocks. The model generates reasonably large momentum profits and investment dynamics of momentum portfolios as in the data.;The second chapter is a coauthored with Frederico Belo and Vito Gala. Using a novel measure of industry exposure to government spending, we document predictable variation in cash flows and stock returns over political cycles. During Democratic presidencies, firms with high government exposure experience higher cash flows and stock returns, while the opposite pattern holds true during Republican presidencies. Business cycles, firm characteristics, and standard risk factors do not account for the pattern in returns across presidencies. An investment strategy that exploits the presidential cycle predictability generates abnormal returns as large as 6.9% per annum. Our results suggest market under reaction to predictable variation in the effect of government spending policies.;The third chapter is a joint work with Jianfeng Yu. Motivated by psychological evidence on limited investor attention and anchoring, we propose two proxies for the degree to which traders under- and over-react to news, namely, the nearness to the Dow 52-week high and the nearness to the Dow historical high, respectively. We find that nearness to the 52-week high positively predicts future aggregate-market returns, while nearness to the historical high negatively predicts future market returns. We further show that our proxies contain information about future market returns that is not captured by traditional macroeconomic variables and that our results are robust across G7 countries. Comprehensive Monte Carlo simulations and comparisons with the NYSE/AMEX market cap index confirm the significance of these findings.