Failure of Factor Models in Explaining Individual Stock Returns: Evidence from a Predictability Test

We find a pricing-residual reversal pattern for well-known asset pricing models: the CAPM, Fama-French, Hou-Xue-Zhang, Stambaugh-Yuan, and Daniel-Hirshleifer-Sun. A trading strategy that buys low pricing-residual stocks and sells high pricing-residual ones earns significant average and risk-adjusted returns, and it performs similarly across all the models. This is also true for statistical models with factors extracted from 105 anomalies. The pricing-residual reversal is unexplained by investor sentiment, limits-to-arbitrage, prospect theory, and expectation extrapolation, suggesting that new factors are needed to better understand the cross section of stock returns.