Initial Underreaction Research Articles

Inflation Expectations with Finite Horizon Planning

Under finite horizon planning, households and firms evaluate a full set of state-contingent paths along which the economy might evolve out to a finite horizon but have limited ability to process events beyond that horizon. We show--analytically and empirically--that such a model accounts for an initial underreaction and subsequent overreaction of inflation forecasts. A planning horizon of four quarters can account for the evidence on the predictability of inflation forecast errors and macroeconomic data. Our identification and estimation strategies combine full-information methods based on aggregate data with regression-based estimates that directly use inflation expectations data.

Dynamic information aggregation: Learning from the past

With dispersed information, how much can agents learn from past endogenous aggregates such as prices or output? In a rational-expectations equilibrium, if general equilibrium effects are strong enough, aggregates no longer perfectly reveal underlying fundamentals. In this confounding regime, the effects of informational frictions are persistent over time, and the aggregate outcome displays an initial under-reaction followed by a delayed over-reaction relative to its perfect-information counterpart. In a standard New Keynesian model, we show that endogenous information aggregation helps bring the model predictions on aggregate forecasts closer to the data.

Top investment banks, confirmation Bias, and the market pricing of forecast revisions

We investigate the impact of top investment banks (hereafter top IBs) on the pricing of forecast revisions through the investors' attention channel by examining the distraction effect and confirmation bias theories. The distraction effect theory predicts that investors' attention shifts to consensus revisions that align with revisions from top IBs, resulting in inattention to other revisions. This theory implies that top IBs primarily benefit investors by directing them to high-quality revisions. In contrast, the confirmation bias theory predicts that top IBs magnify market reaction to forecast revisions and benefit investors by partially offsetting investors' initial underreaction to revisions. Our findings indicate the presence of confirmation bias. We further examine the potential effects of the information content of revisions, analyst agreement, news sentiment, and information uncertainty to test the robustness of our results. Our findings suggest that top IBs ultimately contribute to the price discovery process by attracting investors' attention and this effect does not channel through the quality of consensus revisions.

Volatility Expectations and Returns

ABSTRACTWe provide evidence that agents have slow‐moving beliefs about stock market volatility that lead to initial underreaction to volatility shocks followed by delayed overreaction. These dynamics are mirrored in the VIX and variance risk premiums, which reflect investor expectations about volatility, and are also supported in both surveys and firm‐level option prices. We embed these expectations into an asset pricing model and find that the model can account for a number of stylized facts about market returns and return volatility that are difficult to reconcile, including a weak or even negative risk‐return trade‐off.

Under-reaction in the sovereign CDS market

The sovereign CDS market has developed rapidly for two decades and currently has a gross notional amount of more than a trillion dollars. We document a strong momentum effect in this market, which cannot be explained by a large set of risk factors. These momentum returns are positively skewed and higher during recessions. Consistent with the interpretation that this momentum effect is due to investors’ initial underreaction to sovereign credit information followed by corrections, our evidence shows that the momentum returns tend to be higher during the months surrounding announcements of credit rating or outlook changes of the underlying countries.

Diagnostic bubbles

We introduce diagnostic expectations into a standard setting of price formation in which investors learn about the fundamental value of an asset and trade it. We study the interaction of diagnostic expectations with learning from prices and speculation (buying for resale). With diagnostic (but not with rational) expectations, these mechanisms lead to price paths exhibiting three phases: initial underreaction, then overshooting (the bubble), and finally a crash. With learning from prices, the model generates price extrapolation as a by-product of beliefs about fundamentals, lasting only as the bubble builds up. When investors speculate, even mild diagnostic distortions generate substantial bubbles.

Under-reaction in the Sovereign CDS Market

The sovereign CDS market has developed rapidly for two decades and currently has a gross notional amount of more than a trillion dollars. We document a strong momentum effect in this market, which cannot be explained by a large set of risk factors. These momentum returns are positively skewed and higher during recessions. Consistent with the interpretation that this momentum effect is due to investors’ initial underreaction to sovereign credit information followed by corrections, our evidence shows that the momentum returns tend to be higher during the months surrounding announcements of credit rating or outlook changes of the underlying countries.

Revisiting the (Mis)Pricing of Accruals

ABSTRACT Our paper examines inconsistent conclusions regarding the accrual anomaly and demonstrates the importance of aligning regression specifications with hypotheses. Richardson, Sloan, Soliman, and Tuna (2005) conclude that accruals are mispriced and the mispricing seems to increase as accrual reliability decreases. Barone and Magilke (2009) and Ball, Gerakos, Linnainmaa, and Nikolaev (2016) conclude that cash flows rather than accruals are mispriced. We show that the divergent conclusions come from misalignment between the null hypothesis and regression specification in Richardson et al. (2005). In addition, analysis of the contemporaneous relations between stock returns and components of earnings supports an initial underreaction to cash flows by investors. We fail to detect links between the reliability measures in Richardson et al. (2005) and investor behavior once we align the statistical tests with the null hypothesis. Our reexamination of prior findings benefits accounting academics, standard setters, and others interested in how investors use earnings components. JEL Classifications: M41. Data Availability: All data used in this study are publicly available from the sources identified in the text.

Volatility Expectations and Returns

We provide evidence that agents have slow-moving beliefs about stock market volatility that lead to initial underreaction to volatility shocks followed by delayed overreaction. These dynamics are mirrored in the VIX and variance risk premiums which reflect investor expectations about volatility and are also supported in surveys and in firm-level option prices. We embed these expectations into an asset pricing model and find that the model can account for a number of stylized facts about market returns and return volatility which are difficult to reconcile, including a weak, or even negative, risk-return tradeoff.

Analysts’ reinitiations of coverage and market underreaction

Abstract I study the informativeness of reinitiations of coverage, which are defined as the resumption of coverage of a stock by a broker after more than six months of interruption. Reinitiations are associated with a significant short-term market response, in particular when the same analyst is assigned to the stock. However, I show that this market response is incomplete. Interestingly, the price patterns that follow the issuance of regular upgrades of recommendation and reinitiations differ significantly. Prices adjust quickly after a regular upgrade, while reinitiations are followed by a sustained price increase in the following six months, which does not revert during the following two years. I assess the economic magnitude of this initial underreaction by setting up a trading strategy. I show that reinitiations of coverage are the only type of recommendation that delivers significant positive abnormal returns after transaction costs with a three- and six-month investment horizon. I study and reject several candidate explanations in relation to momentum, and PEAD. Then, I investigate an information/superior ability hypothesis. I find that reinitiations are a more accurate signal than other recommendation types. Besides, the earnings conference call transcripts show that those analysts were able to maintain active relationships with the firms, even during the interruption of coverage. Their activity level is associated with more informative reinitiations of coverage. In particular, their participation rank in conference calls, which can be seen as a proxy for ability and proximity to the management appears to be a strong predictor of the drift after the reinitiation takes place.

Confirming Signals are Hard to Resist: Blessing and Curse of Information Under Confirmation Bias

Ample empirical evidence documents that individuals pay more attention to confirming than to contradicting evidence. In the context of the so-called confirmation bias, we first study the effects of additional information on perception correctness - contrasting the competing effects of total signal precision and the possibility to search for the most suitable signal. We provide the testable hypothesis that managers inform about bad news in a more diffuse signal compared to good news. This in turn provides an explanation of the dispersion anomaly: disperse signals are followed by underperformance. Second, we study the effects of confirmation bias in an overlapping generations model with a continuous signal distribution. Several results of more simplified models do not hold true any longer - e.g. confirmation bias leads to initial underreaction instead of overreaction. In a framework with endogenous market entry and exit, this initial underreaction triggers subsequent overreaction. This momentum effect is accompanied by time varying market participation, announcement day and market depth effects.

Bitcoin as an alternative investment vehicle

This paper documents time series momentum in Bitcoin returns. The paper finds persistence in returns for one to 8 weeks that partially reverses over longer horizons, consistent with sentiment theories of initial under-reaction and delayed over-reaction. The time series momentum in Bitcoin returns is similar to that of the other asset returns while the time span is much shorter. This may be due to much quicker nature and shorter term memory of Bitcoin investors. A combined portfolio of S&P500 and Bitcoin momentum strategy shows enhanced expected return, skewness, kurtosis and Value at Risk for given levels of portfolio return volatility.

Stock–Bond Correlation and Duration Risk Allocation

Using weekly stock-bond correlations estimated with highfrequency data, the authors find that a lower (more negative) stock-bond correlation forecasts falling 10-year interest rates over the coming weeks. It also forecasts falling oneyear interest rates over the next year. The reverse is true when the stock-bond correlation is higher (more positive). Therefore investors, in particular those with long-term, bond-like liabilities, should take greater duration risk when the recent stock-bond correlations are lower. The authors propose two possible explanations of such predictive power: (1) the markets and/or policymakers’ underreaction to the changing economic conditions the stock-bond correlation implies; and (2) the markets’ initial underreaction to the long-term bonds’ safe-haven status.

Portfolio construction based on information uncertainty measures and its effects on momentum return

One of the key areas of behavioral finance is investor's reaction to the uncertain environment in which is located where a series of factors, investor's individual and social psychology and experience, are involved in his/her decision-making. In fact, information uncertainty has been considered by different researchers as one of the realities of financial trade environment, particularly related to behavioral finance. To the extent that most of studies have recognized it as the basis of the formation of behavioral errors, including initial under-reaction (due to the conservatism and anchoring) or overreaction to the new released news that leads to momentum return. But there is no Consensus to measure information uncertainty. This study aimed to examine new measurement to determine information uncertainty based on firm specific factors. our results show that this method of, momentum portfolio construction leads more return comparing older method using other criteria for measuring information uncertainty.

The impact of Financial Times Deutschland news on stock prices: post-announcement drifts and inattention of investors

In this paper, we analyze the impact of Financial Times Deutschland (FTD) news on stock prices and trading volumes. Based on a sample of all news about German DAX, MDAX, and SDAX companies published in the news section of the FTD between 2006 and 2010, our results show that articles that contain positive (negative) information are associated with significantly positive (negative) abnormal returns and abnormal trading volumes around their publication. Furthermore, our results show an initial underreaction to these articles and subsequent post-publication drift. Based on the inattention hypothesis, we show that high-attention news (proxied by abnormal trading volume) almost instantaneously moves stock prices to their new valuation levels, whereas the price adjustment process takes much longer following low-attention news. Our results also hold within multivariate regressions where we additionally control for stock-specific characteristics (e.g., institutional ownership, size, and price-to-book ratio) as well as other attention-grabbing events (as measured by ad hoc announcements and cover-page news articles). Finally, we show that results primarily hold in the non-crisis period.

The Impact of Financial Times Deutschland News on Stock Prices – Post Announcement Drifts and Inattention of Investors

Within this paper, we analyze the impact of Financial Times Deutschland (FTD) news on stock prices and trading volumes. Based on a sample of all news on German DAX, MDAX and SDAX companies published within the news section of the FTD between 2006 and 2010, our results show that articles that contain positive (negative) information are associated with significantly positive (negative) abnormal returns and abnormal trading volumes around their publication. Furthermore, our results show an initial underreaction to these articles and a subsequent post publication drift. Based on the inattention hypothesis, we show that high-attention news (proxied by abnormal trading volume) almost instantaneously influence stock prices to reach their new valuation levels, whereas the price adjustment process takes much longer following low-attention news. Our results also hold within multivariate regressions where we additionally control for stock-specific characteristics (e.g., institutional ownership, size and price-to-book ratio) as well as other attention grabbing events (as measured by ad-hoc announcements and cover page news articles). Finally, we show that results primarily hold in the non-crisis period.

On the Anomalous Stock Price Response to Management Earnings Forecasts

Abstract: This paper examines stock price formation subsequent to management forecasts of quarterly earnings. In the post‐announcement period, we find a significant upward price drift for both good news forecasts and bad news forecasts. Combined with the asymmetry in the initial market response, the upward post‐guidance drift in stock prices is consistent with a reversal of an initial overreaction to managers’ bad news forecasts and a continuation of an initial underreaction to managers’ good news forecasts. This interpretation is supported by a negative (positive) relationship between the initial market response and the post‐guidance drift in the bad news (good news) group. The drift pattern is robust to issues arising from measurement. Trading strategies exploiting the post‐announcement drift suggest the existence of economically significant trading profits, net of estimated trading costs.

Time series momentum

We document significant “time series momentum” in equity index, currency, commodity, and bond futures for each of the 58 liquid instruments we consider. We find persistence in returns for one to 12 months that partially reverses over longer horizons, consistent with sentiment theories of initial under-reaction and delayed over-reaction. A diversified portfolio of time series momentum strategies across all asset classes delivers substantial abnormal returns with little exposure to standard asset pricing factors and performs best during extreme markets. Examining the trading activities of speculators and hedgers, we find that speculators profit from time series momentum at the expense of hedgers.

Time Series Momentum

We document significant “time series momentum” in equity index, currency, commodity, and bond futures for each of the 58 liquid instruments we consider. We find persistence in returns for 1 to 12 months that partially reverses over longer horizons, consistent with sentiment theories of initial under-reaction and delayed over-reaction. A diversified portfolio of time series momentum strategies across all asset classes delivers substantial abnormal returns with little exposure to standard asset pricing factors and performs best during extreme markets. Examining the trading activities of speculators and hedgers, we find that speculators profit from time series momentum at the expense of hedgers.

Aggregation of Information and Beliefs: Asset Pricing Lessons from Prediction Markets

This paper analyzes how asset prices in a binary market react to information when traders have heterogeneous prior beliefs. We show that the competitive equilibrium price underreacts to information when there is a bound to the amount of money traders are allowed to invest. Underreaction is more pronounced when prior beliefs are more heterogeneous. Even in the absence of exogenous bounds on the amount traders can invest, prices underreact to information provided traders become less risk averse as their wealth increases. In a dynamic setting, price changes are positively correlated over time. Thus the initial underreaction is followed by momentum.