Abstract
I use a simple vector autoregressive (VAR) model to decompose a typical firm's stock return into two components: changes in cash-flow expectations (i.e., cash-flow news) and changes in discount rates (i.e., expected-return news). The VAR model yields three main results. First, firm-level stock returns are mainly driven by cash-flow news. For a typical stock, the variance of cash-flow news is more than twice that of expected-return news. Second, expected-return news series are highly correlated across firms, while cash-flow news can largely be diversified away in aggregate portfolios. Third, shocks to expected returns and cash flows are, perhaps surprisingly, positively correlated for a typical small stock. This positive correlation is inconsistent with a simple overreaction story suggesting that small-stock investors overreact to positive cash-flow news and thereby drive expected returns down.
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