Can Cash Flow Expectations Explain Momentum and Reversal

Zhongjin Lu

This dissertation delves into the relation between asset returns, risks, and cash flow expectations. The first chapter uses the model-implied patterns of cash flow expectations to differentiate among the three most prominent behavioral theories explaining stock return momentum and reversal. Using analyst earnings forecasts as a proxy for cash flow expectations, I trace the dynamics of the expectation errors for winner and loser stocks in a 24-month holding period, during which returns are characterized by a momentum phase followed by a reversal phase. The large positive cross-sectional difference in expectation errors between winner and loser stocks gradually shrinks to zero over the holding period. This pattern is most consistent with the underreaction hypothesis in Hong and Stein (1999), in which cash flow expectation errors can only explain momentum, and price extrapolation is...