Invisible hands
The Neural Inhibition of Learning Increases Asset Market Bubbles: Experimental Evidence
Levan Efremidze et al.
Journal of Behavioral Finance, Winter 2017, Pages 114-124
Abstract:
The authors tested a leading theory of bubble formation, insufficient learning, in a laboratory asset market using a drug, Naltrexone, which inhibits reinforcement learning. We found that asset price bubbles in Naltrexone sessions were larger compared with placebo sessions, averaging 60% higher in amplitude and 77% larger in the deviation from fundamental value in the final 12-period trading round. There was no difference between conditions in understanding of the trading rules, overconfidence, or confusion. Participants on Naltrexone appeared unable to determine appropriate trading strategies as prices changed. The findings indicate that specific neural mechanism of reinforcement learning is involved in the formation of asset market bubbles.
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In-Group Bias in Financial Markets
Sima Jannati et al.
University of Miami Working Paper, December 2016
Abstract:
This paper investigates in-group bias in financial markets. Specifically, we argue that equity analysts may have less favorable opinions about firms that are not headed by CEOs of their own "group". We define groups based on gender, ethnicity and political attitudes. Examining analysts' earnings forecasts, we find that male analysts have lower assessments of firms headed by female CEOs than of firms headed by male CEOs. Results are very similar if in-groups are defined based on ethnicity or political attitudes: Earnings forecasts of domestic analysts are lower for firms headed by foreign CEOs and earnings forecasts of Republican analysts are lower for firms headed by Democrat CEOs. As a result, earnings surprises of firms headed by female, foreign, or Democrat CEOs are systematically upward biased. Overall, our results provide robust evidence for in-group bias in financial markets.
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CEO Ethnoracial Characteristics and Analyst Forecasts
Musaib Ashraf
University of Arizona Working Paper, December 2016
Abstract:
I analyze the effect of ethnoracial differences between CEOs and analysts on analyst forecasts. I find analyst forecasts are significantly lower and analyst forecast errors are significantly larger when the race of analysts and CEOs differ, while controlling for relevant factors that may affect analyst forecasts (such as return on assets and actual earnings-per-share) and incorporating firm fixed effects. I focus on firms with minority CEOs but find the effect in other settings as well. I also find this effect is offset with selective information sharing with analysts prior to 2000 when Regulation Fair Disclosure was passed. Overall, these results indicate a systematic downwards bias in analyst forecasts for firms with minority CEOs, raising questions about public policy and market efficiency.
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Hispanic Culture, Local Return Chasing, and Momentum Returns
Jawad Addoum, Alok Kumar & Stuart Webb
University of Miami Working Paper, December 2016
Abstract:
We examine the effect of Hispanic culture on portfolio choice decisions and asset returns in the United States. We demonstrate that investors residing in predominantly Hispanic ZIP codes are significantly more likely to chase returns and overweight small, local stocks than the average U.S. investor. Importantly, we find that these results cannot be attributed to unobserved heterogeneity correlated with Hispanic population concentration. We also find evidence that Hispanic investors' preferences affect prices and returns in local asset markets. In particular, momentum in stock returns is more pronounced (nonexistent) among firms headquartered in MSAs with a high (low) proportion of Hispanics. Further, high-Hispanic MSAs experience larger housing booms and subsequent busts than low-Hispanic localities.
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Investment Professionals' Ability to Detect Deception: Accuracy, Bias and Metacognitive Realism
Maria Hartwig et al.
Journal of Behavioral Finance, Winter 2017, Pages 1-13
Abstract:
In the first empirical study on the topic, the authors examined the ability of investment professionals to distinguish between truthful and deceptive statements. A random sample of 154 investment professionals made judgments about a series of truthful and deceptive statements, some of which involved financial fraud. Investment professionals' lie detection accuracy was poor; participants performed no better than would be expected by chance. Accuracy in identifying lies about financial fraud was especially poor. Further, participants displayed poor metacognitive realism when assessing their own performance. The theoretical and practical implications for lie detection in the financial industry are discussed.
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Investor Sentiment and Economic Forces
Junyan Shen, Jianfeng Yu & Shen Zhao
Journal of Monetary Economics, April 2017, Pages 1-21
Abstract:
Economic theory suggests that pervasive factors should be priced in the cross-section of stock returns. However, our evidence shows that portfolios with higher risk exposure do not earn higher returns. More important, our evidence shows a striking two-regime pattern for all 10 macro-related factors: high-risk portfolios earn significantly higher returns than low-risk portfolios following low-sentiment periods, whereas the exact opposite occurs following high-sentiment periods. These findings are consistent with a setting in which market-wide sentiment is combined with short-sale impediments and sentiment-driven investors undermine the traditional risk-return tradeoff, especially during high-sentiment periods.
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Do Stocks Outperform Treasury Bills?
Hendrik Bessembinder
Arizona State University Working Paper, January 2017
Abstract:
Most common stocks do not outperform Treasury Bills. Fifty eight percent of common stocks have holding period returns less than those on one-month Treasuries over their full lifetimes on CRSP. When stated in terms of lifetime dollar wealth creation, the entire gain in the U.S. stock market since 1926 is attributable to the best-performing four percent of listed stocks. These results highlight the important role of positive skewness in the cross-sectional distribution of stock returns. The skewness in long-horizon returns reflects both that monthly returns are positively skewed and the fact that compounding returns over multiple periods itself induces positive skewness. The results also help to explain why active strategies, which tend to be poorly diversified, most often underperform.
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Do Weather-Induced Moods Affect the Processing of Earnings News?
Ed Dehaan, Joshua Madsen & Joseph Piotroski
Journal of Accounting Research, forthcoming
Abstract:
We investigate whether unpleasant environmental conditions affect stock market participants' responses to information events. We draw from psychology research to develop a new prediction that weather-induced negative moods reduce market participants' activity levels. Exploiting geographic variation in equity analysts' locations, we find compelling evidence that analysts experiencing unpleasant weather are slower or less likely to respond to an earnings announcement relative to analysts responding to the same announcement but experiencing pleasant weather. Price association tests find evidence consistent with reduced activity due to weather-induced moods delaying equilibrium price adjustments following earnings announcements. We also use our analyst-based research design to re-examine an existing prediction that unpleasant weather induces investor pessimism, and find evidence of both analyst pessimism and reduced activity in the presence of unpleasant weather. Together, our study provides new evidence that both extends and reaffirms findings of a relation between unpleasant weather and market activities, and contributes to the broader psychology and economics literature on the impact of weather-induced mood on labor productivity.
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From Returns to Tweets and Back: An Investigation of the Stocks in the Dow Jones Industrial Average
Pieter de Jong, Sherif Elfayoumy & Oliver Schnusenberg
Journal of Behavioral Finance, Winter 2017, Pages 54-64
Abstract:
A sizeable percentage of investors are using social media to obtain information about companies (Cogent Research [2008]). As a consequence, social media content about firms may have an impact on stock prices (Hachman [2011]). Various studies utilize social media content to forecast stock market-related factors such as returns, volatility, or trading volume. The objective of this article is to investigate whether a bidirectional intraday relationship between stock returns and volatility and tweets exists. The study analyzed 150,180 minute-by-minute stock price and tweet data for the 30 stocks in the Dow Jones Industrial Average over a random 13-day interval from June 2 to June 18, 2014 using a BEKK-MVGARCH methodology. Findings indicate that 87% of stock returns are influenced by lagged innovations of the tweets data, but there is little evidence to support that the direction is reciprocal, with only 7% of tweets being influenced by lagged innovations of the stock returns. Results further show that the lagged innovations from 40 percent of stock returns affect the current conditional volatility of the tweets, while 73 percent of tweets affect the current conditional volatility of stock returns. Moreover, there is strong evidence to suggest that the volatility originating from the returns to the tweets persists for 33 percent of stocks; the volatility originating from the tweets to the returns persists for 73 percent of stocks. Last, 53 percent of stocks exhibit both immediate and persistent impacts from returns to tweets, while 90 percent of stocks exhibit both immediate and persistent impacts from tweets to returns. These results may help traders achieve superior returns by buying and selling individual stocks or options. Also, asset and mutual fund managers may benefit by developing a social media strategy.
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Dangerous infectious diseases: Bad news for Main Street, good news for Wall Street?
Michael Donadelli, Renatas Kizys & Max Riedel
Journal of Financial Markets, forthcoming
Abstract:
We examine whether investor mood, driven by World Health Organization (WHO) alerts and media news on dangerous infectious diseases, is priced in pharmaceutical companies' stocks in the United States. We argue that disease-related news (DRNs) should not trigger rational trading. We find that DRNs have a positive and significant sentiment effect among investors (on Wall Street). The effect is stronger (weaker) for small (large) companies, who are less (more) likely to engage in the development of new vaccines. A potential negative investor climate (on Main Street) - induced by disease-related fear - does not alter the positive sentiment effect.
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Sentiment and Stock Returns: Anticipating a Major Sporting Event
Brian Payne, Jiri Tresl & Geoffrey Friesen
Journal of Sports Economics, forthcoming
Abstract:
This study documents the effect of the Super Bowl on the stock returns of firms that are geographically associated with the competing teams. We find significant upward return drift in the 9 trading days leading up to the Super Bowl, a pattern consistent with investors trading in anticipation of the game itself. The "anticipatory behavior" among investors leads to widespread pregame returns, which is not documented in prior studies. These pre-event abnormal returns are positive and statistically and economically significant for all firms, and the size of pre-event returns varies according to each team's favored status. In addition, firms associated with the winning team exhibit significant positive return drift over the 10-day period after their win. Firms associated with the losing team exhibit moderate downward drift. Our findings are strongest among the smallest quintile of firms and are robust to various risk adjustments and using a matched sample control group. The collective findings suggest that only by standing on the sideline will investors avoid winning around the Super Bowl.
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Byoung-Hyoun Hwang & Hugh Hoikwang Kim
Journal of Financial Economics, forthcoming
Abstract:
We quantify the effects of easy-to-read disclosure documents on firm value by analyzing shareholder reports of closed-end investment companies in which the company's value can be estimated separately from the value of the company's underlying assets. Using a copy-editing software application that counts the pervasiveness of the most important 'writing faults' that make a document harder to read, our analysis provides evidence that issuing financial disclosure documents with low readability causes firms to trade at significant discounts relative to the value of their fundamentals. Our estimates suggest that a one-standard-deviation decrease in readability decreases firm value by a full 2.5%. In situations in which investors are more likely to rely on annual reports, the readability effect on firm value increases to 3.3%.
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The Persistent Effect of Initial Success: Evidence from Venture Capital
Ramana Nanda, Sampsa Samila & Olav Sorenson
Harvard Working Paper, January 2017
Abstract:
We used data on individual investments in the portfolios of venture capital firms to study persistence in their performance. Each additional IPO among a VC's first five investments predicted a 13% higher IPO rate for its subsequent 50 investments. Roughly half of this performance persistence stemmed from investment "styles" ― investing in particular regions and industries. We found no evidence of performance persistence stemming from a differential ability to select or govern portfolio companies. Rather, our results suggest that early success in venture investing yields better deal flow in subsequent investments, thereby perpetuating differences in the outcomes of initial investments.
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Kenneth Merkley, Roni Michaely & Joseph Pacelli
Journal of Finance, forthcoming
Abstract:
We examine changes in the scope of the sell-side analyst industry and whether these changes impact information dissemination and the quality of analysts' reports. Our findings suggest that changes in the number of analysts covering an industry impact analyst competition and have significant spillover effects on other analysts' forecast accuracy, bias, report informativeness, and effort. These spillover industry effects are incremental to the effects of firm level changes in analyst coverage. Overall, a more significant sell-side analyst industry presence has positive externalities that can result in better functioning capital markets.
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Political money contributions of U.S. IPOs
Dimitrios Gounopoulos et al.
Journal of Corporate Finance, April 2017, Pages 19-38
Abstract:
We produce the first study to explore the effect of political money contributions on IPOs. Exploiting a hand-collected database, we show that both lobbying and PAC expenditure pay off on issue day as donors incur less underpricing, an effect that can be amplified by contribution size and strategic targeting of recipients. Investigating the causes in multiple channels, we also associate donor IPOs with negative offer price revisions and lower aftermarket volatility. Collectively, our results offer new empirical grounding to the information asymmetry theory.
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Information Shocks and Short-Term Market Underreaction
George Jiang & Kevin Zhu
Journal of Financial Economics, forthcoming
Abstract:
Using jumps in stock prices as a proxy for large information shocks, we provide evidence consistent with short-term underreaction in the US equity market. Strategies long (short) stocks with positive (negative) lagged jump returns earn significantly positive returns over the next one- to three-month horizons. The results based on intraday jumps, especially overnight jumps, provide further evidence consistent with underreaction. The underreaction is robust to controlling for other firm characteristics, extends stock return momentum over intermediate to short horizons, and captures market underreaction to information shocks beyond earnings surprises. We further show that limited investor attention contributes to short-term underreaction.
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Perceptions and Price: Evidence from CEO Presentations at IPO Roadshows
Elizabeth Blankespoor, Bradley Hendricks & Gregory Millee
Journal of Accounting Research, forthcoming
Abstract:
This paper examines the relation between cognitive perceptions of management and firm valuation. We develop a composite measure of investor perception using 30-second content-filtered video clips of initial public offering (IPO) roadshow presentations. We show that this measure, designed to capture viewers' overall perceptions of a CEO, is positively associated with pricing at all stages of the IPO (proposed price, offer price and end of first day of trading). The result is robust to controls for traditional determinants of firm value. We also show that firms with highly perceived management are more likely to be matched to high-quality underwriters. In further exploratory analyses, we find the impact is greater for firms with more uncertain language in their written S-1. Taken together, our results provide evidence that investors' instinctive perceptions of management are incorporated into their assessments of firm value.
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Outcomes of Investing in OTC Stocks
Joshua White
U.S. Securities & Exchange Commission Working Paper, December 2016
Abstract:
This paper analyzes three aspects of over-the-counter (OTC) stocks: (1) the recent trends in the OTC stock market structure and size; (2) the documented properties of OTC stocks; and (3) the differences in returns based on investor and stock characteristics. Approximately 10,000 OTC stocks were quoted at the end of 2013 through 2015, generating a total trading volume of over $200 billion per year. Dollar volume has grown substantially since 2012 and is now concentrated in the segment of the OTC market with no requirements of registration or reporting to the U.S. Securities and Exchange Commission (SEC). A synthesis of recent academic literature reveals troubling properties of OTC stocks. Academic studies find that OTC stocks tend to be highly illiquid; are frequent targets of alleged market manipulation; generate negative and volatile investment returns on average; and rarely grow into a large company or transition to listing on a stock exchange. Moreover, these properties tend to worsen when the OTC company has fewer disclosure-related eligibility requirements. I examine the relationship between OTC investor demographics and investment outcomes using a proprietary database of transaction-level OTC data with confidential investor information. Analysis of 1.8 million trades by over 200,000 individual investors confirms that the typical OTC investment return is severely negative. Investor outcomes worsen for OTC stocks that experience a promotional campaign or have weaker disclosure-related eligibility requirements. Demographic analysis reveals that older, retired, low-income, and less educated investors experience significantly poorer outcomes in OTC stock markets. Given that retail investors are the predominant owners of OTC stocks, and the documented trend towards less transparent OTC companies, the results of this study have important implications for investor protection.
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Uncovering Expected Returns: Information in Analyst Coverage Proxies
Charles Lee & Eric So
Journal of Financial Economics, forthcoming
Abstract:
We show that analyst coverage proxies contain information about expected returns. We decompose analyst coverage into abnormal and expected components using a simple characteristic-based model and show that firms with abnormally high analyst coverage subsequently outperform firms with abnormally low coverage by approximately 80 basis points per month. We also show abnormal coverage rises following exogenous shocks to underpricing and predicts improvements in firms' fundamental performance, suggesting that return predictability stems from analysts more heavily covering underpriced stocks. Our findings highlight the usefulness of analysts' actions in expected return estimations, and a potential inference problem when coverage proxies are used to study information asymmetry and dissemination.
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A Mind Is a Terrible Thing to Change: Confirmatory Bias in Financial Markets
Sebastien Pouget, Julien Sauvagnat & Stephane Villeneuve
Review of Financial Studies, forthcoming
Abstract:
This paper studies the impact of the confirmatory bias on financial markets. We propose a model in which some traders may ignore new evidence inconsistent with their favorite hypothesis regarding the state of the world. The confirmatory bias provides a unified rationale for several existing stylized facts, including excess volatility, excess volume, and momentum. It also delivers novel predictions for which we find empirical support using data on analysts' earnings forecasts: traders update beliefs depending on the sign of past signals and previous beliefs, and, at the stock level, differences of opinion are larger when past signals have different signs.
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Asset Managers: Institutional Performance and Smart Betas
Joseph Gerakos, Juhani Linnainmaa & Adair Morse
NBER Working Paper, December 2016
Abstract:
Using a dataset of $17 trillion of assets under management, we document that actively-managed institutional accounts outperformed strategy benchmarks by 86 (42) basis points gross (net) during 2000-2012. In return, asset managers collected $162 billion in fees per year for managing 29% of worldwide capital. Estimates from a Sharpe (1992) model imply that their outperformance comes from factor exposures ("smart beta"). If institutions had instead implemented mean-variance portfolios of institutional mutual funds, they would not have earned higher Sharpe ratios. Recent growth of the ETF market implies that asset managers are losing advantages held during our sample period.