Earnings Belief Risk and the Cross-Section of Stock Returns

We show in a theoretical asset pricing model incorporating heterogeneous beliefs that the expected excess return on a risky asset depends on its exposure to the risk arising from innovations in the average belief of investors about the expected return of a representative asset. Using the actual EPS data and the analyst EPS forecast data provided by I/B/E/S, we construct a market-wide average belief measure, which we call "the earnings belief measure." We find that the average return on stocks with high sensitivity to earnings belief shocks is 7.14% per year higher than that on stocks with low sensitivity. This positive relationship holds after accounting for traditional risk factors, is prominent among large-cap stocks, and is invariant across sentiment levels.