Price Underreaction Research Articles

Investor heterogeneity and anchoring-induced momentum

This paper investigates how anchoring-induced investors’ trading behavior drives momentum anomaly. The results show that price momentum does not retain its ability to predict future returns after considering the stock’s nearness to its 52-week high. The stock price’s nearness to the 52-week high is a stronger return predictor for stocks with a higher retail trading proportion. This suggests an anchoring-induced momentum pattern, which is affected by investor heterogeneity. Our trading flow analysis reveals that retail investors are subject to anchoring bias. Their trading behavior causes price underreaction to good (bad) information for stocks traded near (far from) their 52-week high.

Momentum and individual investor trades: Evidence from Singapore

This paper examines the role of retail investor trading activity on stock price momentum. We find that there is little evidence of momentum for stocks traded on the Singapore Exchange (SGX) unconditionally and momentum is concentrated in stocks with high market capitalization and high nominal prices. While these stocks are likely to be the trading habitat of institutional investors, they exhibit substantially greater price momentum when they are accompanied by heavy trading by retail investors. Moreover, contrarian trading by retail investors on momentum stocks increases stock price underreaction to information and generates momentum of above 2% per month.

Endogenous inattention and risk-specific price underreaction in corporate bonds

Corporate bond prices are slow to respond to default risk and interest rate shocks, as proxied by firm-level stock returns and Treasury returns, respectively. Furthermore, the underreaction is risk-specific: bonds with better credit quality underreact more to default risk, while those with worse quality underreact more to interest rates. The underreactions imply substantial out-of-sample return predictability, and investors appear to be leaving too much money on the table. The results are consistent with behavioral inattention models in which investors endogenously allocate more attention to payoff-relevant (or salient) risks, and they are not explained by traditional trading friction mechanisms.

Language barriers in analyst reports

This study explores whether language barriers affect investors’ reactions to textual information in analyst reports. To this end, we compare the price reaction to the linguistic tone in Japanese and U.S. reports and analyze the effect of an English translation on that reaction. We find that prices react significantly to the linguistic tone in both Japanese and U.S. reports. However, we only observe a statistically significant price underreaction to Japanese reports. Further, the existence of an English translation mitigates this price underreaction. These findings support the view that language barriers induce investors to underreact to textual information.

Underreaction to Macroeconomic News Announcements and the Downward-Sloping Security Market Line

The relationship between market beta and expected returns is positive on days with pre-scheduled macroeconomic news announcements (MNAs), but negative on the other days. This paper shows evidence that stock price underreaction to MNAs explains these phenomena. First, I use high-frequency S&P 500 futures data to identify positive (good) and negative (bad) news from macro announcements. Stocks with low sensitivities to bad macro news perform relatively well on announcement days and poorly on the following non-announcement days. Moreover, the under-performance of low sensitivity stocks is most pronounced when investor disagreement is high and short-selling constraints are binding. Subsequently, I show that the relation between market betas and returns on announcement (non-announcement) days is particularly positive (negative) among stocks with low sensitivities to bad macro news. The results are consistent with stocks, especially those with high market betas, underreact to bad news on MNA days when high shorting costs prevent prices from reflecting pessimists’ beliefs, and experience low returns on the following non-announcement days.

Improving momentum strategies using residual returns and option‐implied information

AbstractThis paper provides an alternative method for enhancing momentum profits by combining residual returns and option‐implied information. The results show that the main benefit of applying residual returns to construct momentum portfolios is generating stable returns. Additionally, the incorporation of implied volatility (IV) spread or IV skew into a residual momentum portfolio is found to significantly raise profits, particularly during bad times and high‐sentiment periods. This is because IV spread and IV skew can dissociate winners/losers with a price underreaction from those with a price overreaction, which suggests that informed traders who perceive price underreactions/overreactions trade in option markets.

On the Survival of Conservatism Traders in an Asset Market with Strategic Interaction

This paper examines a static model of an asset market with rational traders, conservatism traders and noise traders. Both rational and conservatism traders receive an informational signal about the asset payoff before any trade takes place. Conservatism traders are slow to update their conditional mean of the asset payoff relative to rational traders. To maximize their own expected profits, all rational and conservatism traders strategically submit their market orders to the market maker. This paper proves analytically that conservatism traders cannot survive. The implication of the results suggests that the anomaly of asset price underreaction to new information is a short-lived phenomenon.

Textual Opinion in Analyst Reports

A large body of research studies shows that the quantitative outputs of analyst reports (e.g., earnings forecasts and recommendations) have informational value. In this study, by analyzing the textual tone of headlines in analyst reports, I reveal that textual opinion in the reports – a representative qualitative output – contains incremental information that has a significant impact on stock prices. The analysis reveals that stock prices react considerably to the report tone. In addition, economically and statistically significant price drifts, indicating price underreaction, are observed in cases of negative report tone. However, these price behaviors are relatively weak when the report tone is used to support quantitative measures. In sum, textual opinion in reports by itself provides value-relevant information, especially when textual opinion is used to provide independent information.

Prices and Price Limits

This paper studies the effects of price limits implemented by the Securities and Exchange Commission (SEC) after the May 2010 ‘Flash Crash.’ The security-level price limits halt trading after a security’s price experiences a sudden and large movement. The difference-in-difference design exploits the staggered introduction of the limits to address omitted variable concerns. The data show that price limits reduce the frequency and severity of extreme price movements, but induce price underreaction. The results are consistent with Subrahmanyam’s (1997) theory that price limits cause informed traders to be less aggressive.

Investor Preference and Stock Price Underreaction: Evidence from Post Earnings Announcement Drift

This paper shows investors’ preference for right-skewed, lottery-like payoffs can eliminate price underreaction to extremely good earnings news. Such news enhance investors’ preference for lottery-like stocks, leading to preference-based trades that accelerate price adjustments. We find PEAD disappears for stocks with strong ex ante lottery-like features and extremely good earnings news. Arbitrage does not explain this finding because it persists when arbitrage costs and information asymmetry are high. Corroborating the disappearance of PEAD, the above stocks also experience greater price reactions to earnings news. Consistent with the prevalence of lottery preference among individual investors, we find they purchase more lottery-like stocks upon extremely good earnings news and the attenuation of PEAD is concentrated in stocks with greater net-buys by them around earnings announcements.

Book Reviews

Jianfeng Yu of the University of Minnesota and PBCSF, Tsinghua University reviews “Asset Price Response to New Information: The Effects of Conservatism Bias and Representativeness Heuristic”, by Guo Yin Luo. The Econlit abstract of this book begins: “Examines the role of conservatism bias and representativeness heuristic in determining asset price overreaction or underreaction to new information. Discusses conservatism bias and asset price overreaction or underreaction to new information in a competitive securities market; conservatism bias and asset price overreaction or underreaction to new information in the presence of strategic interaction; representativeness heuristic and asset price overreaction or underreaction to new information in a competitive securities market; representativeness heuristic and asset price overreaction or underreaction to new information in the presence of strategic interaction; and the presence of representativeness heuristic and conservatism bias in an asset market. Luo is in the DeGroote School of Business at McMaster University.”

Conservatism bias in the presence of strategic interaction

Click to increase image sizeClick to decrease image size Acknowledgements I would like to acknowledge the comments and suggestions from the editors, anonymous reviewers and my colleagues from McMaster Univeristy. Also, financial support from the Social Sciences and Humanities Research Council of Canada (SSHRC) is greatly appreciated.

Do Stock Prices Underreact to Information Conveyed by Investors' Trades? Evidence from China

We examine the process of stock prices adjusting to information conveyed by the trading process. Using the price impact of a trade to measure its information content, we show that the weekly price impact has significant cross-sectional predictive power for returns in the subsequent week. The effect is sensitive to the level of informational asymmetry. We find that the price impact contains information that is not fully captured by public order flows and that a lead–lag effect exists regarding the arrival of information to different groups of investors. Our finding suggests a price under-reaction to trading information, which can be explained by the gradual-information-diffusion theory.

The Representativeness Heuristic and Asset Price Reaction to New Information

In the existing literature, the representativeness heuristic is commonly viewed as a cause of asset price overreaction to new information. This article proves that the representativeness heuristic can cause asset price underreaction to new information in a competitive securities market. Specifically, there is one risk-free asset and one risky asset. Both rational and heuristic traders trade can against each other or against noise traders, whose demand is random. The payoff of the risky asset is unknown but all traders receive an informational signal about the risky asset’s payoff before any trading takes place. Due to the representativeness heuristic, the updated mean of the risky asset’s payoff for heuristic traders is higher (lower) than that for rational traders when the realization of the informational signal is above (below) the expected payoff of the risky asset. The results of this study suggest that regardless of noise traders being net buyers or sellers, the representativeness heuristic causes the asset price to overreact to new information close to the expected payoff of the risky asset and causes the asset price to underreact to new information far above or below the expected payoff of the risky asset. <b>TOPICS:</b>Statistical methods, risk management, in markets

Representativeness Heuristic Can Cause Asset Price Underreaction to New Information in a Competitive Securities Market

In the literature, representativeness heuristic is commonly viewed as a cause of asset price overreaction to new information. This paper proves that representativeness heuristic can cause asset price under-reaction to new information in a competitive securities market. Specifically, there is one risk-free asset and one risky asset. Both rational and heuristic traders trade can against each other or against noise traders whose demand is random. The payoff of the risky asset is unknown but all traders receive an informational signal about the risky asset’s payoff before any trading takes place. Due to the representativeness heuristic, the updated mean of the risky asset’s payoff for heuristic traders is higher (lower) than that for rational traders when the realization of the informational signal is above (below) the expected payoff of the risky asset. The results of the paper suggest that regardless of noise traders being net buyers or sellers, the representativeness heuristic causes the asset price to overreact to new information close to the expected payoff of the risky asset and causes the asset price to underreact to new information far above or below the expected payoff of the risky asset.

Do Stock Prices Underreact to Information Conveyed by Investors' Trades?

We examine the process of stock prices adjusting to information conveyed by the trading process. Using the price impact of a trade to measure its information content, our analysis shows that the weekly price impact of market transactions has significant cross-sectional predictive power for returns in the subsequent week. The effect is sensitive to the level of informational asymmetry and is not due to excess liquidity demands or variations in rational risk premia. This finding suggests that prices may slowly incorporate trading information. We then characterize the key channel through which price underreaction occurs. We find that the price impact contains information that is not fully captured by public order flows and that a lead-lag effect exists regarding the arrival of information to different groups of investors. Hong and Stein’s (1999) gradual-information-diffusion theory seems the most likely explanation for price underreaction.

Knowledge discovery in corporate events by neural network rule extraction

Over the last two decades, artificial neural networks (ANN) have been applied to solve a variety of problems such as pattern classification and function approximation. In many applications, it is desirable to extract knowledge from trained neural networks for the users to gain a better understanding of the network's solution. In this paper, we use a neural network rule extraction method to extract knowledge from 2222 dividend initiation and resumption events. We find that the positive relation between the short-term price reaction and the ratio of annualized dividend amount to stock price is primarily limited to 96 small firms with high dividend ratios. The results suggest that the degree of short-term stock price underreaction to dividend events may not be as dramatic as previously believed. The results also show that the relations between the stock price response and firm size is different across different types of firms. Thus, drawing the conclusions from the whole dividend event data may leave some important information unexamined. This study shows that neural network rule extraction method can reveal more knowledge from the data.

A Tale of Two Anomalies: The Implications of Investor Attention for Price and Earnings Momentum

We examine the role of investor attention in explaining the profitability of price and earnings momentum strategies. Using trading volume and market state to measure cross-sectional and time-series variations of investor attention, we find that price momentum profits are higher among high volume stocks and in up markets, but that earnings momentum profits are higher among low volume stocks and in down markets. In the long run, price momentum profits reverse but earnings momentum profits do not. These results suggest that price underreaction to earnings news weakens with investor attention, but price continuation caused by investors' overreaction strengthens with attention.

Prospect theory, mental accounting, and momentum

The tendency of some investors to hold on to their losing stocks, driven by prospect theory and mental accounting, creates a spread between a stock's fundamental value and its equilibrium price, as well as price underreaction to information. Spread convergence, arising from the random evolution of fundamental values and the updating of reference prices, generates predictable equilibrium prices interpretable as possessing momentum. Empirically, a variable proxying for aggregate unrealized capital gains appears to be the key variable that generates the profitability of a momentum strategy. Controlling for this variable, past returns have no predictability for the cross-section of returns.

Under- and Over-Reaction from Relative and Aggregate Overconfidence

This paper offers a continuous time, general equilibrium model where a risky asset is traded among risk-averse overconfident investors. Two kinds of overconfidence are introduced: investors exhibit relative overconfidence if each investor believes her model is better than others' and aggregate overconfidence if they believe signals have more information content than those in the true model. Relative overconfidence creates market price underreaction, while aggregate overconfidence generates overreaction. Excess trading volume is generated from relative overconfidence but not aggregate overconfidence. A high equity premium and excess price change volatility result from aggregate overconfidence in the early stages of investors' extrapolation of information, but not in the steady state.