We provide a theory and evidence for when the Capital Asset Pricing Model fails.
When investors disagree about the common factor of cash-flows, high beta assets are
more sensitive to this aggregate disagreement than low beta ones and hence experience
a greater divergence-of-opinion about their cash-flows. Costly short-selling then results
in high beta assets experiencing binding short-sales constraints and being over-priced.
When aggregate disagreement is low, the Security Market Line is upward sloping due to
risk-sharing. But when it is large, the Security Market Line is initially increasing and
then decreases with beta. At the same time, high beta assets in a dynamic setting also
have greater share turnover. Using the dispersion of stock analysts’ earnings forecasts
to measure speculative disagreement, we find strong support for these predictions. (Coauthor David Sraer)
Electronic copy available at: http://ssrn.com/abstract=1967462