Research-Thesis: To what extent does salience theory explain the cross-section of stock returns in the german equity market, and how do different market states influence this relationship?

Abstract

This thesis examines the extent to which salience theory explains the cross-section of stock returns in the German equity market and investigates how different market states influence this relationship. Using a comprehensive sample of German equities spanning December 1988 to December 2023, a monthly salience measure is constructed and tested through quintile portfolio sorts, Fama-MacBeth cross-sectional regressions, a market state analysis, and a country-specific recalibration of the distortion parameter.

The central finding is that stocks with higher salience measures earn significantly lower subsequent returns, consistent with the prediction that investors overweight salient payoff realizations and thereby generate temporary overpricing. This negative relation is robust across all model specifications and survives risk adjustment under a six-factor model.

The effect is structurally concentrated among smaller, less liquid firms where limits to arbitrage are most binding, and largely absent in the large-cap segment, consistent with international evidence. The market state analysis provides only limited evidence of state dependence: although the effect is directionally stronger during high-volatility and low-sentiment periods, differences across regimes are not statistically significant. A country-specific recalibration of the distortion parameter, motivated by evidence on lower risk tolerance and higher uncertainty avoidance among German investors, yields qualitatively similar findings.

Taken together, the results suggest that salience theory provides a meaningful but structurally conditioned explanation for return predictability in the German equity market, operating as a stable behavioral mechanism rather than a conditionally amplified anomaly.