Trading Up
Wisdom of Crowds: The Value of Stock Opinions Transmitted Through Social Media
Hailiang Chen et al.
Review of Financial Studies, May 2014, Pages 1367-1403
Abstract:
Social media has become a popular venue for individuals to share the results of their own analysis on financial securities. This paper investigates the extent to which investor opinions transmitted through social media predict future stock returns and earnings surprises. We conduct textual analysis of articles published on one of the most popular social media platforms for investors in the United States. We also consider the readers' perspective as inferred via commentaries written in response to these articles. We find that the views expressed in both articles and commentaries predict future stock returns and earnings surprises.
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Exuberance Out of Left Field: Do Sports Results Cause Investors to Take Their Eyes Off the Ball?
Christos Pantzalis & Jung Chul Park
Journal of Economic Behavior & Organization, forthcoming
Abstract:
This study investigates whether stock price performance contains a sizeable component that emanates from local sports sentiment. We measure sports sentiment by the performance of sports teams from the four major professional sports leagues (NFL, MLB, NBA, and NHL) that are based nearby firms’ headquarters. We find that concurrent stock returns and sports performances associated with the same locality are highly correlated. Consistent with the notion that mispricing is indeed caused by sports sentiment, we also determine that sentiment is related to a subsequent gradual return reversal, which occurs over the following three year period. In addition, we confirm that local comovement is more pronounced in the presence of sports sentiment in support of the notion that local stock preference of relatively less sophisticated retail investors can be driven by factors that are not information-based. Finally, we devise investment strategies based on recent past observations of sports sentiment and find that they generate sizable abnormal returns, especially in cases of firms located in areas where fan base support appears to be stronger.
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Did Regulation Fair Disclosure, SOX, and Other Analyst Regulations Reduce Security Mispricing?
Edward Lee, Norman Strong & Zhenmei (Judy) Zhu
Journal of Accounting Research, forthcoming
Abstract:
Between 2000 and 2003 a series of disclosure and analyst regulations curbing abusive financial reporting and analyst behavior were enacted to strengthen the information environment of U.S. capital markets. We investigate whether these regulations reduced security mispricing and increased stock market efficiency. After the regulations, we find a significant reduction in short-term stock price continuation following analyst forecast revisions and earnings announcements. The effect was more pronounced among higher information uncertainty firms, where we expect security valuation to be most sensitive to regulation. Analyst forecast accuracy also improved in these firms, consistent with reduced mispricing being due to an improved corporate information environment following the regulations. Our findings are robust to controls for time trends, trading activity, the financial crisis, analyst coverage, delistings, and changes in information uncertainty proxies. We find no concurrent effect among European firms and a regression discontinuity design supports our identification of a regulatory effect.
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Attracting Investor Attention through Advertising
Dong Lou
Review of Financial Studies, forthcoming
Abstract:
This paper provides evidence that managers adjust firm advertising, in part, to attract investor attention and influence short-term stock returns. First, I show that increased advertising spending is associated with a contemporaneous rise in retail buying and abnormal stock returns, and is followed by lower future returns. Second, I document a significant increase in advertising spending prior to insider sales and a significant decrease in the subsequent year. Additional analyses suggest that the inverted V-shaped pattern in advertising spending around insider sales is most consistent with managers' opportunistically adjusting firm advertising to exploit the temporary return effect to their own benefit.
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Harold Cole & Thomas Cooley
NBER Working Paper, March 2014
Abstract:
For decades credit rating agencies were viewed as trusted arbiters of creditworthiness and their ratings as important tools for managing risk. The common narrative is that the value of ratings was compromised by the evolution of the industry to a form where issuers pay for ratings. In this paper we show how credit ratings have value in equilibrium and how reputation insures that, in equilibrium, ratings will reflect sound assessments of credit worthiness. There will always be an information distortion because of the fact that purchasers of ratings need not reveal them. We argue that regulatory reliance on ratings and the increasing importance of risk-weighted capital in prudential regulation have more likely contributed to distorted ratings than the matter of who pays for them. In this respect, much of the regulatory obsession with the conflict created by issuers paying for ratings is a distraction.
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Have Rating Agencies Become More Conservative? Implications for Capital Structure and Debt Pricing
Ramin Baghai, Henri Servaes & Ane Tamayo
Journal of Finance, forthcoming
Abstract:
Rating agencies have become more conservative in assigning corporate credit ratings over the period 1985 to 2009; holding firm characteristics constant, average ratings have dropped by three notches. This change does not appear to be fully warranted because defaults have declined over this period. Firms affected more by conservatism issue less debt, have lower leverage, hold more cash, are less likely to obtain a debt rating, and experience lower growth. Their debt spreads are lower than those of unaffected firms with the same rating, which implies that the market partly undoes the impact of conservatism on debt prices. This evidence suggests that firms and capital markets do not perceive the increase in conservatism to be fully warranted.
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Predicting anomaly performance with politics, the weather, global warming, sunspots, and the stars
Robert Novy-Marx
Journal of Financial Economics, May 2014, Pages 137–146
Abstract:
Predictive regressions find that the party of the US president, the weather in Manhattan, global warming, the El Niño phenomenon, sunspots, and the conjunctions of the planets all have significant power predicting the performance of popular anomalies. The interpretation of these results has important implications for the asset pricing literature.
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Drew Creal, Robert Gramacy & Ruey Tsay
Journal of Business & Economic Statistics, forthcoming
Abstract:
We present a methodology for rating in real-time the creditworthiness of public companies in the U.S. from the prices of traded assets. Our approach uses asset pricing data to impute a term structure of risk neutral survival functions or default probabilities. Firms are then clustered into ratings categories based on their survival functions using a functional clustering algorithm. This allows all public firms whose assets are traded to be directly rated by market participants. For firms whose assets are not traded, we show how they can be indirectly rated by matching them to firms that are traded based on observable characteristics. We also show how the resulting ratings can be used to construct loss distributions for portfolios of bonds. Finally, we compare our ratings to Standard & Poors and find that, over the period 2005 to 2011, our ratings lead theirs for firms that ultimately default.
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The Long-Run Role of the Media: Evidence from Initial Public Offerings
Laura Xiaolei Liu, Ann Sherman & Yong Zhang
Management Science, forthcoming
Abstract:
The unique characteristics of the U.S. initial public offering (IPO) process, particularly the strict quiet period regulations, allow us to explore the effects of media coverage when the coverage does not contain genuine news (i.e., hard information that was previously unknown). We show that a simple, objective measure of pre-IPO media coverage is positively related to the stock's long-term value, liquidity, analyst coverage, and institutional investor ownership. Our results are robust to additional controls for size, to using abnormal or excess media, and to an instrumental variable approach. We also find that pre-IPO media coverage is negatively related to future expected returns, measured by the implied cost of capital. In all, we find a long-term role for media coverage, consistent with Merton's attention or investor recognition hypothesis.
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Leverage and Beliefs: Personal Experience and Risk Taking in Margin Lending
Peter Koudijs & Hans-Joachim Voth
NBER Working Paper, March 2014
Abstract:
What determines risk-bearing capacity and the amount of leverage in financial markets? Using unique archival data on collateralized lending, we show that personal experience can affect individual risk-taking and aggregate leverage. When an investor syndicate speculating in Amsterdam in 1772 went bankrupt, many lenders were exposed. In the end, none of them actually lost money. Nonetheless, only those at risk of losing money changed their behavior markedly – they lent with much higher haircuts. The rest continued as before. The differential change is remarkable since the distress was public knowledge. Overall leverage in the Amsterdam stock market declined as a result.
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Equity Analyst Recommendations: A Case for Affirmative Disclosure?
William Baker & Gregory Dumont
Journal of Consumer Affairs, Spring 2014, Pages 96–123
Abstract:
The financial well-being of retail investors is impacted by the quality of their investment decisions. Inaccurate or misleading financial information that is misconstrued by investors to be reliable can compromise decision making. This research reports on the results of three studies that show despite the fact that equities with “buy” ratings significantly underperform equities with “hold” ratings, retail investors rely on them when making investment decisions. It also shows analysts' guidance remains inaccurate in the aggregate despite the passage of Sarbanes-Oxley and related legislation/regulation. This article begins a conversation on the implications of this dilemma, specifically the value of affirmative disclosure as a remedy.
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Short Sellers and Innovation: Evidence from a Quasi-Natural Experiment
Jie He & Xuan Tian
University of Georgia Working Paper, January 2014
Abstract:
We examine the causal effect of short selling on innovation. Using exogenous variation in short-selling costs generated by a quasi-natural experiment, Regulation SHO, which randomly assigns a subsample of the Russell 3000 index firms into a pilot program, we show that short selling has a positive, causal effect on firm innovation. The positive effect of short selling on innovation is more pronounced when firms are subject to greater agency problems between shareholders and managers and a higher degree of information asymmetry. Our evidence is consistent with the hypothesis that short sellers encourage innovation both by disciplining managers through their active trading and monitoring and by mitigating information asymmetry through their information production activities about firm fundamentals. Our paper provides new insights into the real effects of short selling and has important policy implications for security laws and regulations that aim to encourage innovation.
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Does Short Selling Amplify Price Declines or Align Stocks with Their Fundamental Values?
Asher Curtis & Neil Fargher
Management Science, forthcoming
Abstract:
Critics of short selling argue that short sellers amplify price declines by targeting firms with falling prices in an unwarranted manner. Contrary to this viewpoint, we find that increases in short interest for firms following a price decline are associated with measures of overpricing based on financial statement analysis. Our results extend to short-selling activity following marketwide declines. We also find evidence consistent with the profitability of short selling following price declines being driven by valuation-based positions. Overall, our findings suggest short sellers primarily undertake valuation-based strategies following price declines and have implications for regulators. Limiting short selling following price declines is likely to impede efficient price discovery.
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Miguel Antón & Christopher Polk
Journal of Finance, forthcoming
Abstract:
We connect stocks through their common active mutual fund owners. We show that the degree of shared ownership forecasts cross-sectional variation in return correlation, controlling for exposure to systematic return factors, style and sector similarity, and many other pair characteristics. We argue that shared ownership causes this excess comovement based on evidence from a natural experiment — the 2003 mutual fund trading scandal. These results motivate a novel cross-stock-reversal trading strategy exploiting information in ownership connections. We show that long-short hedge fund index returns covary negatively with this strategy, suggesting these funds may exacerbate this excess comovement.
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Scale and Skill in Active Management
Lubos Pastor, Robert Stambaugh & Lucian Taylor
NBER Working Paper, February 2014
Abstract:
We empirically analyze the nature of returns to scale in active mutual fund management. We find strong evidence of decreasing returns at the industry level: As the size of the active mutual fund industry increases, a fund's ability to outperform passive benchmarks declines. At the fund level, all methods considered indicate decreasing returns, but estimates that avoid econometric biases are insignificant. We also find that the active management industry has become more skilled over time. This upward trend in skill coincides with industry growth, which precludes the skill improvement from boosting fund performance. Finally, we find that performance deteriorates over a typical fund's lifetime. This result can also be explained by industry-level decreasing returns to scale.
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Winners in the spotlight: Media coverage of fund holdings as a driver of flows
David Solomon, Eugene Soltes & Denis Sosyura
Journal of Financial Economics, forthcoming
Abstract:
We show that media coverage of mutual fund holdings affects how investors allocate money across funds. Fund holdings with high past returns attract extra flows, but only if these stocks were recently featured in the media. In contrast, holdings that were not covered in major newspapers do not affect flows. We present evidence that media coverage tends to contribute to investors’ chasing of past returns rather than facilitate the processing of useful information in fund portfolios. Our evidence suggests that media coverage can exacerbate investor biases and that it is the primary mechanism that makes fund window dressing effective.
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Jeffrey Busse, Amit Goyal & Sunil Wahal
Review of Finance, April 2014, Pages 561-590
Abstract:
We examine active retail mutual funds and institutional products with a mandate to invest in global equity markets. We find little reliable evidence of alphas in the aggregate or on average. The right tail of the distribution contains some large alphas. Decomposing stock selection from country selection, we find some evidence of superior stock picking abilities in the extreme right tail. However, simulations suggest that they are produced just as likely by luck as by skill. Persistence tests show little evidence of continuation in superior performance.
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Do Security Analysts Speak in Two Tongues?
Ulrike Malmendier & Devin Shanthikumar
Review of Financial Studies, May 2014, Pages 1287-1322
Abstract:
Why do security analysts issue overly positive recommendations? We propose a novel approach to distinguish strategic motives (e.g., generating small-investor purchases and pleasing management) from nonstrategic motives (genuine overoptimism). We argue that nonstrategic distorters tend to issue both positive recommendations and optimistic forecasts, while strategic distorters “speak in two tongues,” issuing overly positive recommendations but less optimistic forecasts. We show that the incidence of strategic distortion is large and systematically related to proxies for incentive misalignment. Our “two-tongues metric” reveals strategic distortion beyond those indicators and provides a new tool for detecting incentives to distort that are hard to identify otherwise.
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Analyst herding and investor protection: A cross-country study
A.G. Kerl & T. Pauls
Applied Financial Economics, Spring 2014, Pages 533-542
Abstract:
Using a multi-national data set, we investigate the herding behaviour of financial analysts. Our results across a range of different countries suggest that analysts consistently deviate from their true forecasts and issue earnings forecasts that are biased by anti-herding. Furthermore, the level of bias (i.e. anti-herding) seems to be systematically higher for forecasts on companies from European countries compared to the US or Japan. We argue that such differences might stem from diverse levels of investor protection and corporate governance as analysts deviate less from true forecasts when the overall information environment is more transparent and company disclosures are of higher quality. Thereby, we proxy investor protection based on the company-level share of institutional ownership as well as on country-level investor protection measures. Our results show that increasing levels of investor protection and corporate governance mitigate the anti-herding behaviour. Especially, when companies that are located in high investor protection countries are held by an increasing number of institutional investors, analysts are most reluctant to issue biased forecasts.
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How Constraining Are Limits to Arbitrage? Evidence from a Recent Financial Innovation
Alexander Ljungqvist & Wenlan Qian
NBER Working Paper, January 2014
Abstract:
Limits to arbitrage play a central role in behavioral finance. They are thought to interfere with arbitrage processes so that security prices can deviate from true values for extended periods of time. We describe a recent financial innovation that allows limits to arbitrage to be sidestepped, and overvaluation thereby to be corrected, even in settings characterized by extreme costs of information discovery and severe short-sale constraints. We report evidence of shallow-pocketed “arbitrageurs” expending considerable resources to identify overvalued companies and profitably correcting overpricing. The innovation that allows the arbitrageurs to sidestep limits to arbitrage involves credibly revealing their information to the market, in an effort to induce long investors to sell so that prices fall. This simple but apparently effective way around the limits suggests that limits to arbitrage may not always be as constraining as sometimes assumed.