Cause of Return Reversal: Information Monopoly Hypothesis

Abstract

Return reversal in the stock markets has been a puzzle for researchers. Several hypotheses have been proposed to explain this pervasive phenomenon. Such explanations provide valuable insight to the understanding of investors’ reactions but may not address the cause. In this paper, we propose the Information Monopoly Hypothesis (IMH) to fill this gap. According to the IMH, a strategic trader generates, or obtains, potentially price-lifting information. He then initiates purchases of that particular stock quietly. The information generator then disseminates the same information through a credible channel with a large investor audience; therefore, the information gets substantial publicity and credibility. Immediately after the public release of the information, numerous investors react to it by generating buying pressure in a rush, resulting in a price jump. In the meanwhile, the strategic trader begins the distribution of the shares he accumulated earlier. He closes his position at an unfair profit by trading against the induced investors. His distribution (sale) and diminishing buy volume from induced investors jointly results in a sharp return reversal or downward drifting. For potentially price-depressing information, all trade and price movement directions follow an opposite pattern. The key to return reversal in the large number of empirical studies and securities litigation cases lies in the inducement of investors, according to the potentially pricemoving information, and trading against them after the public release of the information. What is the power that induces numerous investors to trade according to the information? We propose to call that power an information monopoly. Its components are the information with price-moving potential, its publicity, and credibility. The strategic trader exercises an information monopoly power in his trading strategy. The information monopoly enables his trading strategy to be manipulative and causes a subsequent return reversal. This is a simple description of the Information Monopoly Hypothesis. We test the IMH by studying recent securities litigation cases of market manipulation as well as empirical research on sell-side analyst recommendations, and we find these to be consistent with our hypothesis.