Abstract
ABSTRACTWe document that stocks that have optimistic (pessimistic) consensus recommendations and are currently held by many short‐term institutions exhibit large stock‐return reversals: Their large past outperformance (underperformance) is followed by large negative (positive) future alphas. The predictable return reversals originate from overreaction to past recommendation releases and the correction of these overreactions around future releases. Results are stronger when earnings news is released and at firms with higher fundamental uncertainty. Further, firms with more short‐term institutions show stronger announcement returns and price drift after recommendation changes. Our results are consistent with models of higher order beliefs where short‐term institutions coordinate trading around public signals.
Highlights
In standard asset-pricing models with a representative investor, higher order beliefs—that is, investor beliefs about the beliefs of other investors—do not matter, and stock prices reflect the discounted expected value of future dividends
We demonstrate that short-term institutional ownership and extreme analyst recommendations (“strong buys” and “sells”) are meanreverting over periods of one to two years but not in related ways, which implies that both variables are strongly predictable
We document that the presence of short-term institutions, combined with extreme analyst recommendations, is associated with return reversals
Summary
In standard asset-pricing models with a representative investor, higher order beliefs—that is, investor beliefs about the beliefs of other investors—do not matter, and stock prices reflect the discounted expected value of future dividends. The model by Kondor [2012] predicts that, in the presence of short-term investors, earnings news can polarize higher order beliefs about the stock price (i.e., lead to more disagreement).4 Consistent with this prediction, the reversal pattern in CARs of high fund-turnover stocks is more pronounced when recommendations are released around earnings news. Allen, Morris, and Shin [2016] and Banerjee, Kaniel, and Kremer [2009] predict that, in the presence of higher order beliefs traders, stock prices exhibit drift after public signals are released; that is, prices move only slowly toward fundamental values This effect should be strong at stocks whose ownership includes many short-term institutions. We validate these results by documenting strong price reactions and drift at high fund-turnover stocks during the 1998–2000 tech bubble (a period in which widespread bubble-like mispricing has been documented).5 This evidence supports the predictions of higher order beliefs models but not the information-source hypothesis. We contribute to this literature by demonstrating that analyst recommendations are key to understanding the mixed effects of shortterm institutional ownership on stock returns
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