What Drives Anomaly Returns?

We provide novel evidence on which theories best explain stock return anomalies. Our estimates reveal whether anomaly returns arise from variation in the underlying firms' cash flows or their discount rates. For each of five well-known anomalies, we find that cash flow shocks explain more variation in anomaly returns than discount rate shocks. The cash flow and discount rate components of each anomaly's returns are negatively correlated. Most correlations between anomaly and market return components are small. Our evidence is inconsistent with theories of time-varying risk aversion and theories of common shocks to investor sentiment. It is most consistent with theories in which investors overextrapolate firm-specific cash flow news and those in which firm risk increases following negative cash flow news.