A recent paper by Conrad, Kapadia, and Xing (2014) shows that stocks with a high probability of extreme positive payoffs (jackpots) subsequently earn low returns. We find that stocks with a high probability of extreme negative returns (crashes) earn abnormally low average returns and that the cross-sectional return predictability of crash probability completely subsumes the jackpot effect. We also find that stocks with high crash probability clearly underperform, regardless of level of institutional ownership or variations in investor sentiment. Moreover, institutional demand for stocks with high crash probability increases until their prices arrive at the peak of overvaluation. Our evidence contradicts the presumption that
sophisticated investors are always willing to trade against mispricing, and it suggests that the crash effect we find could arise partially from rational speculative bubbles, not entirely from sentiment-driven overpricing.
JEL classification: G11; G12
Keywords: Price crashes; Cross-section of stock returns; Anomalies; Institutional investors; Rational speculative bubbles
