Asset Pricing with Price Levels

Abstract

We propose a novel way to study asset prices based on price distortions rather than abnormal returns. We derive the correct identity linking current mispricing to subsequent returns, generating a price-level analogue to the fundamental asset pricing equation, E[MR^e]=0, used to study returns. Our empirical test reveals that the CAPM describes the cross-section of prices better than it describes expected short-horizon returns. Despite the improvement, significant mispricing remains. An interaction of book-to-market and quality provides a parsimonious model of CAPM mispricing that both long-term buy-and-hold investors and researchers disciplining models from the price perspective should prioritize.