Abstract
Recent studies report that the size effect in the cross-section of U.S. stock returns has disappeared after the early 1980s. We examine whether the disappearance of the size effect in realized returns can be attributed to unexpected shocks to the profitability of small and big firms. We show that small firms experience large negative profitability shocks after the early 1980s, while big firms experience large positive shocks. As a result, realized returns of small and big firms over this period differ substantially from expected returns. After adjusting for the price impact of profitability shocks, we find that there still is a robust size effect in expected returns. Our results suggest that in-sample cash flow shocks can significantly affect inferences about predictability in the cross-section of stock returns.
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