What Drives Anomaly Returns?

We provide novel evidence on which theories best explain stock return anomalies by decomposing anomaly portfolio returns into components driven by the underlying …rms’cash ‡ows or their discount rates. For each of …ve well-known anomalies, we …nd that cash ‡ow shocks explain more variation in anomaly portfolio returns than discount rate shocks. The cash ‡ow and discount rate components of each anomaly’s returns are negatively correlated. Discount rate shocks to a mean-variance e¢ cient portfolio constructed from these anomalies are slightly negatively correlated with discount rate shocks to the market portfolio, while the cash ‡ow shocks are uncorrelated with market cash ‡ow shocks. Our evidence is inconsistent with theories of time-varying risk aversion and theories of common shocks to investor sentiment. It is most consistent with theories in which investors overextrapolate …rm-speci…c cash ‡ow news and those in which …rm risk increases following negative cash ‡ow news. Comments welcome. We thank Francisco Gomes and Alan Moreira, as well as seminar participants at the Chicago Asset Pricing Conference, Columbia University, Copenhagen Business School, Cornell University, London Business School, Swedish House of Finance conference, UC Irvine, for helpful comments. First draft: February 2016. Contact information: Lochstoer: UCLA Anderson School of Management, C-519, 110 Westwood Plaza, Los Angeles, CA 90095. E-mail: [email protected]. Tetlock: 811 Uris Hall, Columbia Business School, 3022 Broadway, New York, NY 10027. E-mail: [email protected].