Left-tail momentum and tail properties of return distributions: A case of Korea

This study documents the importance of considering the cross-sectional differences in the tail properties of stocks' return distributions when analyzing the left-tail momentum (LTM) phenomenon. This phenomenon is verified in the Korean stock markets, which shows that stocks showing large losses in the past tend to continue to perform poorly in the future. However, when tail fatness (TF), measured using standardized return distributions, is considered, the LTM phenomenon is significant only in the low-TF stock group. This means that investors underestimate the persistence of left-tail risk only for stocks with a low frequency of large losses, and not for all stocks that show large losses. The results of the measurement of tail risk (TR) reaffirm the positive relationship with expected returns, which shows that the existence of LTM is verified only in the low-TR stock group, suggesting a need for caution in interpreting the LTM phenomenon with low TR as a market anomaly.     

Which past returns affect trading volume?

Anecdotal evidence suggests and recent theoretical models argue that past stock returns affect subsequent stock trading volume. We study 3,000 individual investors over a 51 month period to test this apparent link between past returns and volume using several different panel regression models (linear panel regressions, negative binomial panel regressions, Tobit panel regressions). We find that both past market returns as well as past portfolio returns affect trading activity of individual investors (as measured by stock portfolio turnover, the number of stock transactions, and the propensity to trade stocks in a given month). After high portfolio returns, investors buy high risk stocks and reduce the number of stocks in their portfolio. High past market returns do not lead to higher risk taking or underdiversification. We argue that the only explanations for our findings are overconfidence theories based on biased self-attribution and differences of opinion explanations for high levels of trading activity.     

Are extreme returns priced in the stock market? European evidence

This paper revisits some recently found evidence in the literature on the cross-section of stock returns for a carefully constructed dataset of euro area stocks. First, we confirm recent results for US data and find evidence of a negative cross-sectional relation between extreme positive returns and average returns after controlling for characteristics such as momentum, book-to-market, size, liquidity and short term return reversal. We argue that this is the case because these stocks have lottery-like characteristics, which is attractive to certain investors. Also, these stocks tend to be very volatile so that arbitrageurs are discouraged from correcting potential mispricing. As a consequence, these stocks are often overpriced and hence face lower expected returns. Second, when we control for extreme returns, the recently found negative relationship between idiosyncratic risk and future returns is less robust. In our models, after adding maximum returns, the relationship is insignificant and sometimes even positive. We also find that idiosyncratic skewness and coskewness play an important role for asset pricing, as predicted by several theoretical models.     

Can financial statement analysis beat consensus analysts’ recommendations?

We examine whether investors can exploit financial statement information to identify companies with a greater likelihood of future earnings increases and whether stocks of those companies generate 1-year abnormal returns that exceed the abnormal returns from following analysts’ consensus recommendations. Our approach summarizes financial statement information into a “predicted earnings increase score,” which captures the likelihood of 1-year-ahead earnings increases. We find that, within our sample of consensus recommendations, stocks with high scores are much more likely to experience future earnings increases than stocks with low scores. A hedge portfolio strategy that utilizes our approach within each consensus recommendation level generates average annual abnormal returns of 10.9 percent over our 12-year sample period, after controlling for previously identified risk factors. These abnormal returns exceed those available from following analysts’ consensus recommendations. Our results show that share prices and consensus recommendations fail to impound financial statement information that helps predict future earnings changes.     

Do Retail Trades Move Markets?

We study the trading of individual investors using transactiondata and identifying buyer- or seller-initiated trades. We documentfour results: (1) Small trade order imbalance correlates wellwith order imbalance based on trades from retail brokers. (2)Individual investors herd. (3) When measured annually, smalltrade order imbalance forecasts future returns; stocks heavilybought underperform stocks heavily sold by 4.4 percentage pointsthe following year. (4) Over a weekly horizon, small trade orderimbalance reliably predicts returns, but in the opposite direction;stocks heavily bought one week earn strong returns the subsequentweek, while stocks heavily sold earn poor returns.     

Media sentiment and short stocks performance during a systemic crisis

During crisis periods, investors often engage in short selling of stocks, in line with their pessimistic view of the present and future market performance as well as with the hope to repurchase the stocks back in the future at much lower prices. This attitude not only affects stock returns, but also may lead to significant risk transmission among assets. Addressing this concern, our study examines the returns and volatility connectedness between media coverage index (MCI) and high short interest stocks during the recent Covid-19 pandemic. We document MCI as a net transmitter for all returns series, whereas the results for volatility series exhibits binary behavior, acting as either a transmitter or recipient depending on the considered sector of economic activity. We highlight that the healthcare and energy sector stocks behave as net recipients of both, returns and volatility; hence, a certain caution is required while including them in investment portfolios. Finally, the causality test indicates that the MCI is more strongly connected with stock returns than with volatilities, thus signaling that media, may not only provoke a rise in stock volatility, but cause intense risk transmission especially during a systemic crisis similar to Covid-19.     

Trading Volume: Implications of an Intertemporal Capital Asset Pricing Model

We derive an intertemporal asset pricing model and explore its implications for trading volume and asset returns. We show that investors trade in only two portfolios: the market portfolio, and a hedging portfolio that is used to hedge the risk of changing market conditions. We empirically identify the hedging portfolio using weekly volume and returns data for U.S. stocks, and then test two of its properties implied by the theory: Its return should be an additional risk factor in explaining the cross section of asset returns, and should also be the best predictor of future market returns.     

A Test of the Errors–in–Expectations Explanation of the Value/Glamour Stock Returns Performance: Evidence from Analysts' Forecasts

Several empirical studies show that investment strategies that favor the purchase of stocks with low prices relative to conventional measures of value yield higher returns. Some of these studies imply that investors are too optimistic about (glamour) stocks that have had good performance in the recent past and too pessimistic about (value) stocks that have performed poorly. We examine whether investors systematically overestimate (underestimate) the future earnings performance of glamour (value) stocks over the 1976 to 1997 period. Our results fail to support the extrapolation hypothesis that posits that the superior performance of value stocks is because investors make systematic errors in predicting future growth in earnings of out–of–favor stocks.     

Differences of Opinion and the Cross Section of Stock Returns

We provide evidence that stocks with higher dispersion in analysts' earnings forecasts earn lower future returns than otherwise similar stocks. This effect is most pronounced in small stocks and stocks that have performed poorly over the past year. Interpreting dispersion in analysts' forecasts as a proxy for differences in opinion about a stock, we show that this evidence is consistent with the hypothesis that prices will reflect the optimistic view whenever investors with the lowest valuations do not trade. By contrast, our evidence is inconsistent with a view that dispersion in analysts' forecasts proxies for risk.     

Idiosyncratic skewness and cross-section of stock returns: Evidence from Taiwan

In this study, we examine whether idiosyncratic skewness (IS) affects the returns of the Taiwan stock market. We find that speculative retail investors prefer positive skewness in stocks that leads them to overprice these stocks. As a result, the IS, that reflects gambling, has a negative relation with future returns. Gambling preferences vary with time, mainly occur during recessions and down markets. Moreover, the negative IS-return relation exists only among firms with prior capital gains. We use a difference-in-difference (DID) framework to mitigate the endogeneity concern and find that this IS effect is more significant among stocks with lower arbitrage limits. The IS effect remains significant even after controlling for the IS risk factor. Overall, the IS effect cannot be explained by either arbitrage limits or risk exposure.     

The price of sin: The effects of social norms on markets

We provide evidence for the effects of social norms on markets by studying “sin” stocks—publicly traded companies involved in producing alcohol, tobacco, and gaming. We hypothesize that there is a societal norm against funding operations that promote vice and that some investors, particularly institutions subject to norms, pay a financial cost in abstaining from these stocks. Consistent with this hypothesis, we find that sin stocks are less held by norm-constrained institutions such as pension plans as compared to mutual or hedge funds that are natural arbitrageurs, and they receive less coverage from analysts than do stocks of otherwise comparable characteristics. Sin stocks also have higher expected returns than otherwise comparable stocks, consistent with them being neglected by norm-constrained investors and facing greater litigation risk heightened by social norms. Evidence from corporate financing decisions and the performance of sin stocks outside the US also suggest that norms affect stock prices and returns.     

The role of future economic conditions in the cross-section of stock returns: Evidence from the US and UK

Our study investigates the explanatory power of future economic conditions on individual stock returns in the US and UK equity markets. We analyse a new trading strategy that is based on rational forecasts of future real activity. In addition, we specifically examine the performance of this trading strategy applied to two different classifications of stocks – procyclical stocks and countercyclical stocks. Our findings indicate a strong persistence in the relationship between returns on pro-cyclical stocks and the business cycle. However, such persistence is not present when moving to counter-cyclical stocks in the US and the UK. From this we suggest that US and UK equity investors who predict future real activity accurately can improve their investment profitability by longing pro-cyclical stocks when they expect future economic conditions to be above the long-run trend and shorting those stocks when future activity is anticipated to be below the steady state.     

High Idiosyncratic Volatility and Low Returns: A Prospect Theory Explanation

The well‐documented negative relationship between idiosyncratic volatility and stock returns is puzzling if investors are risk‐averse. However, under prospect theory, while investors are risk‐averse in the domain of gains, they exhibit risk‐seeking behavior in the domain of losses. Consistent with risk‐seeking investors’ preference for high‐volatility stocks in the loss domain, we find that the negative relationship between idiosyncratic volatility and stock returns is concentrated in stocks with unrealized capital losses, but is nonexistent in stocks with unrealized capital gains. This finding is robust to control for short‐term return reversals and maximum daily return, among other variables.     

The stock market reaction to the 2005 split share structure reform in China

During 2005–2006, the Chinese government implemented the split share structure reform, aimed at eliminating non-tradable shares (NTS), i.e. the shares typically held by the State or by politically connected institutional investors that were issued at the early stage of financial market development. Our analysis, based on the time series of risk factors and on the cross-section of abnormal returns, confirms that the split share structure reform was particularly beneficial for small stocks, stocks characterized by historically poor returns, stocks issued by companies with low transparency and weak governance, and for less liquid stocks. Historically neglected stocks also witnessed an increase in the volume of trading and market prices. We conclude that the reform laid down the conditions for important future changes in ownership, liquidity and corporate governance in China.     

Asset pricing in China's domestic stock markets: Is there a logic?

China's stock markets have grown rapidly since their inception and have become an increasingly important emerging market for international investors. However, there are few systematic studies on how asset prices are formed in Chinese domestic equity markets; popular financial media even depict the market as irrational. In this paper, we study the asset pricing mechanism in the nascent Chinese stock markets, with the objective of identifying variables that capture the cross-sectional variation in average stock returns. We focus on the effects of various market imperfections in China. We find that while the market risk (beta) is not priced, there is a significantly negative relationship between firm-specific risk and expected returns. Chinese investors are willing to pay a significant premium for more liquid stocks or for dividend-paying stocks. Furthermore, investors value local A-shares more if there are offshore counterparts (e.g., B- and H-shares) for foreigners, implying that a Chinese firm with a foreign shareholder base has a lower cost of capital, ceteris paribus. Lastly, as with U.S. and other mature markets, firm size and the book-to-market ratio are systematically related to stock returns. Given market imperfections, stocks are priced rather rationally in China, despite the widespread perception to the contrary.     

Investing for the Long Run when Returns Are Predictable

We examine how the evidence of predictability in asset returns affects optimal portfolio choice for investors with long horizons. Particular attention is paid to estimation risk, or uncertainty about the true values of model parameters. We find that even after incorporating parameter uncertainty, there is enough predictability in returns to make investors allocate substantially more to stocks, the longer their horizon. Moreover, the weak statistical significance of the evidence for predictability makes it important to take estimation risk into account; a long-horizon investor who ignores it may overallocate to stocks by a sizeable amount.     

Media Coverage and the Cross-section of Stock Returns

By reaching a broad population of investors, mass media can alleviate informational frictions and affect security pricing even if it does not supply genuine news. We investigate this hypothesis by studying the cross-sectional relation between media coverage and expected stock returns. We find that stocks with no media coverage earn higher returns than stocks with high media coverage even after controlling for well-known risk factors. These results are more pronounced among small stocks and stocks with high individual ownership, low analyst following, and high idiosyncratic volatility. Our findings suggest that the breadth of information dissemination affects stock returns.     

An analysis of real-estate risk using the present value model

The current study uses a present value model that allows for a time-varying expected discount rate in conjunction with a VAR process to decompose real-estate risk. The study finds that the variance ofunexpected returns accounts for most of the total risk with cash-flow risk accounting for twice as much of the unexplained real-estate risk although discount rate risk is also an important factor. This dominance of cash-flow risk is found to result in a weaker mean reversion process for real estate relative to stocks. Another finding is that real estate investors tend to become apprehensive about the future when news on future cash flow is good, and thus they demand higher expected future returns.     

Inflation Illusion and Post-Earnings-Announcement Drift

This paper examines the cross‐sectional implications of the inflation illusion hypothesis for the post‐earnings‐announcement drift. The inflation illusion hypothesis suggests that stock market investors fail to incorporate inflation in forecasting future earnings growth rates, and this causes firms whose earnings growths are positively (negatively) related to inflation to be undervalued (overvalued). We argue and show that the sensitivity of earnings growth to inflation varies monotonically across stocks sorted on standardized unexpected earnings (SUE) and, consistent with the inflation illusion hypothesis, show that lagged inflation predicts future earnings growth, abnormal returns, and earnings announcement returns of SUE‐sorted stocks. Interestingly, controlling for the return predictive ability of inflation weakens the ability of lagged SUE to predict future returns of SUE‐sorted stocks.     

Local institutional investors,information asymmetries,and equity returns

We examine the informational role of geographically proximate institutions in stock markets. We find that both the level of and change in local institutional ownership predict future stock returns, particularly for firms with high information asymmetry; in contrast, such predictive abilities are relatively weak for nonlocal institutional ownership. The local advantage is especially evident for local investment advisors, high local ownership institutions, and high local turnover institutions. We also find that the stocks that local institutional investors hold (trade) earn higher excess returns around future earnings announcements than those that nonlocal institutional investors hold (trade).