Does the Incongruence of Market Expectations with Fundamentals explain Stock Return Patterns?

This paper uses accounting-based reverse engineering of market expectations to identify potentially mispriced stocks. Building upon the “errors-in-expectations” hypothesis, we develop a theoretically funded yet practical tool for stock screening in this paper. We use the Ohlson (1995) model to apply and extend the framework from the first paper by connecting total stock returns to accounting-based fundamentals and (changes in) expected residual income levels, both in the short-term and long-term future. In a similar manner to Piotroski & So (2012), we construct a scoring index – VScore. VScore includes both fundamental data and short-term market expectations that stem from the theoretical framework we provide beforehand, where short-term expectations perform a verifying function for historical fundamentals for the determination of quality. We document that the book-to-price (B/P) effect is concentrated among firms for which long-term speculation is simultaneously incongruent to the underlying fundamentals and short-term expectation (stocks that combine cheapness with quality), indicating that those stocks are interesting subjects for a more extensive fundamental analysis