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Salient Past Stock Returns and Future Stock Performance

Posted in Animal Spirits

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:

  • For the reverse equal-weighted (value-weighted) salience theory valuation hedge portfolio:
    • Average gross monthly return is 1.91% (0.80%)
    • For a model of stock returns accounting for market, size, book-to-market, momentum and liquidity factors, gross monthly alpha is 2.04% (1.01%).
    • 1.73% (0.89%) of average gross monthly return and 0.82% (0.11%) of 5-factor gross monthly alpha comes from the long side.
  • The effect is consistent across subperiods.
  • The typical stock in extreme salience theory valuation deciles has small market capitalization, low liquidity, high beta, high idiosyncratic volatility and low analyst coverage.
  • Retail investor behavior appears to drive the effect, which is:
    • Stronger among stocks with high retail investor ownership (low institutional ownership).
    • Stronger during times of high investor sentiment, as measured by the Baker-Wurgler sentiment index.
    • Absent when measured with open-to-open daily returns rather than close-to-close.
  • Findings are robust to different ways of measuring stock return salience.

In summary, evidence indicates that recent high (low) attention-grabbing returns do cause stocks to become overvalued (undervalued), with misvaluations tending to reverse at a monthly horizon.

It appears that screening high-salience stocks, as specified above, out of a momentum portfolio may be attractive (similar to the convention of skipping a month between the momentum measurement interval and momentum portfolio formation).

Cautions regarding findings include:

  • Reported performance data are gross, not net. Accounting for costs of monthly portfolio reformation and shorting would reduce these data. The study does not address portfolio turnover.
  • Moreover, the specified hedge portfolio contains stocks that are costly to trade and difficult to short. Trade capacities may be modest (not supporting large funds).
  • The salience theory stock valuation process is beyond the reach of many investors, who would bear fees for delegating the work to an investment manager.

See also “Spectacular ‘New’ Momentum and Reversal?” and “Enhancing Momentum with Relative Trend Strength”.

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