Return Dispersion, Size, and the Cross-Section of Stock Returns - Evidence from the German Stock Market

Abstract

This paper investigates whether return dispersion (RD), proxied by the cross-sectional standard deviation of stock returns, captures variation in returns across German stocks between 1989 and 2010. I address existing evidence based on U.S. equity data that RD may serve as a proxy economic state variable. In the out-of-sample test I confirm the countercyclical character of RD and show that it loads significantly negatively on future equal-weighted average market return. Sorting stocks by their absolute loadings on RD, I uncover the negative pattern in simple average portfolio returns. Further analysis indicates that the negative relationship between absolute loadings on RD and future returns is present only in micro stock subgroup. This finding casts doubt on the RD as proxy for state variable. Instead, it suggests its relation to mispricing and idiosyncratic risk components. As a secondary results I confirm the existence of reversed size effect in German stock market over the considered period.