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Animal Spirits

Are investors and traders cats, rationally and independently sniffing out returns? Or are they cows, flowing with a herd that must know something? These blog entries relate to behavioral finance, the study of the animal spirits of investing and trading.

Financial Markets as Massively Multiplayer Gambling

Are financial markets best viewed as massively multiplayer gambling? In his March 2017 paper entitled “Why Markets Are Inefficient: A Gambling ‘Theory’ of Financial Markets for Practitioners and Theorists”, Steven Moffitt presents a model of financial markets based on the perspective of an analytical/enlightened gambler. The gambler believes that: (1) actions of many players (some astute, some mediocre and some fools) drive prices; and, (2) markets adapt such that all static trading systems eventually fail. The gambler combines fundamental laws of gambling, knowledge of trading strategies of other market participants and data analysis to identify and exploit trading opportunities. The gambler translates this general strategy into a specific plan that algorithmically generate trades. Key aspects of the model are, as proposed: Keep Reading

Salient Past Stock Returns and Future Stock Performance

Do attention-grabbing recent returns reliably indicate overvalued and undervalued stocks? In their December 2016 paper entitled “Salience Theory and Stock Prices: Empirical Evidence”, Mathijs Cosemans and Rik Frehen test the effectiveness of salience theory for predicting stock returns. They hypothesize that investors overweight (underweight) stocks with high (low) attention-grabbing recent past returns, thereby overvaluing (undervaluing) them, and that these misvaluations subsequently reverse. They test this hypothesis by each month:

  1. Measuring a stock’s recent return salience as a non-linear function of the scaled difference in the stock’s return from the average return for all stocks by day over the past month.
  2. Combining the daily data to estimate a full-month salience theory valuation of the stock.
  3. Ranking stocks into tenths (deciles) based on salience theory valuation.
  4. Forming a hedge portfolio that is long (short) the equal-weighted or value-weighted decile of stocks with the highest (lowest) salience theory valuations. [For practical application, results below reverse the long and short sides of this portfolio.]

They also explore how salience effects vary by stock characteristics and for different market conditions. Using daily and monthly returns, book values, market capitalizations and trading volume for a broad sample of U.S. stocks during January 1926 through December 2015, they find that: Keep Reading

The Power of Stories?

Do narratives (stories) sometimes trump rationality in financial markets? In his January 2017 paper entitled “Narrative Economics”, Robert Shiller considers the epidemiology (spread, mutation and fading) of stories as related to economic fluctuations. He explores the 1920-21 depression, the Great Depression of the 1930s, the Great Recession of 2007-9 and the political-economic situation of today as manifestations of popular stories. Based on these examples, other examples from other fields and his experience, he concludes that: Keep Reading

Remedies for Publication Bias, Poor Research Design and p-Hacking?

How can the financial markets research community shed biases that exaggerate predictability and associated expected performance of investment strategies? In his January 2017 paper entitled “The Scientific Outlook in Financial Economics”, Campbell Harvey assesses the conventional approach to empirical research in financial economics, sharing insights from other fields. He focuses on the meaning of p-value, its limitations and various approaches to p-hacking (manipulating models/data to increase statistical significance, as in data snooping). He then outlines and advocates a Bayesian alternative approach to research. Based on research metadata and examples, he concludes that: Keep Reading

Mood Beta as Stock Return Predictor

Do individual stocks react differently and persistently to aggregate investor mood changes? In their December 2016 paper entitled “Mood Beta and Seasonalities in Stock Returns”, David Hirshleifer, Danling Jiang and Yuting Meng investigate whether some stocks have higher sensitivities to investor mood changes (higher mood betas) than others, thereby inducing calendar effects in the cross-section of returns. They specify mood based on three calendar-based U.S. stock market return anomalies:

  1. January (highest average excess return of all months) represents good mood, while October (lowest average excess return of all months) represents bad mood.
  2. Friday (highest average excess return of all days) represents good mood, while Monday (lowest average excess return of all days) represents bad mood.
  3. The two days before holidays (abnormally high average excess return) represent good mood, while the two days after holidays (abnormally low average excess return) represent bad mood.

They structure their investigation via a factor model of stock returns, with mood as a factor. They measure a stock’s mood beta by regressing its returns during high and low mood intervals versus contemporaneous equal-weighted market returns over a rolling historical window. Each year, they regress a stock’s monthly January and October returns versus monthly equal-weighted market returns for those months over the last 10 years. Each week, they regress a stock’s daily Friday and Monday returns versus contemporaneous equal-weighted market returns for those days over the last ten weeks. Each holiday, they regress a stocks pre-holiday and post-holiday daily returns versus versus equal-weighted market returns for those days over the last year (including the same holiday the previous year. They then use the stock’s mood betas to predict its returns during subsequent times of good and bad mood. Using daily and monthly stock returns for a broad sample of U.S. common stocks during January 1963 through December 2015, they find that: Keep Reading

How Investors Really Treat Dividends

Do investors treat stock dividends as part of total returns, or do they view them as a separate income stream? In their December 2016 paper entitled “The Dividend Disconnect”, Samuel Hartzmark and David Solomon investigate whether trading and pricing of stocks exhibit a “free dividend” fallacy (disregard for the fact that dividends directly debit stock price as paid). Specifically, they test whether investors: (1) consider both dividends and capital gains when evaluating stock performance; (2) view dividend stocks differently based on market conditions/competing sources of return; and, (3) reinvest dividends and capital gains differently. Using daily individual trader data during January 1991 through November 1996, quarterly institutional and mutual fund holdings data (SEC filings) during 1980 through 2015 and contemporaneous daily stock and stock index prices, return and dividend data, they find that: Keep Reading

Hedge Fund Manager Personal Risk Taking vs. Investment Performance

Do hedge fund managers who seek excitement as indicated by choice of cars invest differently from those who do not? In their December 2016 paper entitled “Sensation Seeking, Sports Cars, and Hedge Funds”, Yan Lu, Sugata Ray and Melvyn Teo investigate the relationship between hedge fund manager personal car selection (body style, maximum horsepower, maximum torque, passenger volume and safety ratings) and fund performance. After identifying a large set of hedge fund managers, they match managers to cars and car characteristics via VIN Place, Autocheck, cars.com, cars-data and the Insurance Institute for Highway Safety, categorizing cars as sports cars, minivans or other based on body style. They then relate hedge fund manager car data as available to subsequent performance and characteristics of associated hedge funds. Using car data and monthly net-of-fee returns, assets under management and other fund characteristics for 1,774 vehicles (including 163 sports cars and 101 minivans) purchased by 1,144 hedge fund managers during January 1994 through December 2015, they find that: Keep Reading

Exploiting Manufactured Earnings Surprises

Is there a way to tell which corporate executives are manipulating earnings? In their November 2016 paper entitled “Expectations Management and Stock Returns”, Jinhwan Kim and Eric So examine the relationship between firm incentives to manage earnings and stock returns around earnings announcements. They define an expectations management incentives (EMI) indicator that combines three groups of incentives:

  1. Attention – the extent of external scrutiny of reported earnings, consisting of analyst coverage and institutional ownership.
  2. Resources – the capacity to manage expectations, consisting of cash reserves and shareholder equity.
  3. Pressure – unsustainable growth expectations, measured by trailing sales growth.

Specifically, monthly EMI is average percentile rank of analyst coverage, institutional ownership, shareholder equity per share, cash per share and sales growth, divided by the difference between the maximum and minimum percentiles of these characteristics, all as of 12 months ago. Using the specified data and associated returns for a broad sample of U.S. stocks encompassing about 420,000 quarterly earnings announcements during 1985 through 2015, they find that: Keep Reading

When Short Sellers Talk Trash

Do short sellers who publicly attack their targets affect stock prices? How do they choose their targets? In his October 2016 paper entitled “Activist Short-Selling”, Wuyang Zhao studies short sellers who publish adverse research on and/or publicly disparage the stocks they short. To assess unique effects of the negative publicity on targeted stock prices, he compares performances of targeted stocks on negative publicity days with those of the same stocks, and of industry peers with the closest or highest contemporaneous levels of short interest or increases in short interest, on short interest release days (five separate benchmarks). To identify characteristics of firms that attract activist short sellers, he examines 12 indicators of stock overvaluation and nine measures of uncertainty about firm prospects. Based on initial tests, he constructs aggregate metrics for overvaluation (averaging seven of the overvaluation indicators) and uncertainty (averaging six of the uncertainty measures) for subsequent tests. Using stock prices and firm characteristics related to 6,197 cases of activist short selling reported in Seeking Alpha or Activist Shorts Research during mid-February 2006 through December 2015, he finds that: Keep Reading

High Prices Mean Good Stocks?

Are stocks with high prices or low prices inherently better deals? In their October 2016 paper entitled “Nominal Stock Price Investing”, Ulrich Hammerich, Christian Fieberg and Thorsten Poddig examine the relationship between stock price and future stock performance in the German equity market. Specifically, they each month sort stocks by price and measure the difference in average total returns between the equally weighted tenth (decile) of stocks with the highest prices and the equally weighted decile with the lowest prices. Using monthly prices and total returns for a broad set of German stocks from the end of January 1990 through December 2013, they find that: Keep Reading

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