Effect of Investor on Cross-Sectional Stock - Case Study Example

Running Head: INVESTOR SENTIMENT AND STOCK RETURNS Effect of Investor Sentiment on Cross Sectional Stock Returns of the of the institution] Abstract We learn how investor sentiment affects the cross-section of stock returns. We have forecasted that a wave of investor sentiment excessively affects securities whose valuation are highly prejudiced and are tricky to arbitrage. We find that when start of period proxy for investor sentiment are low, succeeding returns are comparatively high on small stocks, young stocks, high volatility stocks, unprofitable stocks, non dividend-paying stocks, extreme-growth stocks, and concerned stocks, suggestive of that such stocks are relatively under priced in low-sentiment states. When emotion is high, on the other hand, the pattern largely reverses, symptomatic of that these category of stocks are comparatively expensive in high-sentiment states. Executive Summary Traditional finance theories leave no role for investor emotion. In this theory, most investor is coherent and diversifies to optimize the numerical property of their portfolios. Competition among them leads to a balance in which prices equal the reasonably inexpensive value of expected cash flows, and in which the cross-section of predictable returns depends only on the cross-section of systematic risks. Even if some investors are irrational, classical theory argues, their strain are offset by arbitrageurs with no momentous impact on prices. In this paper, we present evidence that investor sentiment may have major effects on the cross-section of stock prices. Review of Literature: Effect of Investor Sentiment on Cross Sectional Stock Returns Introduction Investment sentiments with in the stock market and the effect of investor emotions on stock returns are certainly the first issue that investors should consider. At the outset, investing is an act of faith, a willingness to postpone present consumption and save for the future. Investing for the long term is central to the achievement of optimal returns by investors. Unfortunately, the principle of investing for the long term-eschewing funds with high turnover portfolios and holding shares in soundly managed funds as investments for a lifetime- is honoured more in the breach than in the observance by most mutual fund managers and shareholders. (Arbel, 1983 44) The term second-hand information refers to information that has been collected from public sources and manipulated or simply reported again by a public news source. Prior research documents the existence of abnormal returns upon the announcement of secondhand information in the form of analysts' recommendations published in a variety of business periodicals. These abnormal returns generally are found to be short-lived. Explanations of the abnormal returns associated with second-hand information include the fact that the market may be inefficient; that second-hand information increases attention focused on the company; that it increases the volume of trading, putting price pressure on the company's stock; and that it provides new information about the company's future prospects or reduces uncertainty associated with previous reports about the company. The objective of this study is to provide additional evidence on the impact of secondhand information on stock prices. We examine a source of information heretofore untested in the finance literature: stock purchase recommendations contained in the widely read weekly business periodical Barron's. The different sources of information in Barron's allow us to examine additional explanations of the impact of second-hand information. We also explore the impact of firm size on the stock price reaction to the disclosure of second-hand information. Literature Review The results provide additional evidence that second-hand information has an impact on stock prices. Consistent with prior studies of other sources of second-hand information, the results show that Barron's recommendations have a substantial impact on stock prices but that the results do not persist into the future. We also find an inverse relationship between firm size and the abnormal returns associated with the second-hand information. A critical review of the literature related to the noise hypothesis of Black (1986 17) and Shleifer and Summers (1990 54). They have argued that if a number of investors are not fully balanced and their demand for risky possessions is affected by their beliefs or sentiments that are not fully justified by essential news and that arbitrage - distinct as trading by fully balanced investors not subject to sentiment - is risky and therefore limited, then changes in investor sentiment are not fully counter by arbitrageurs and may affect security returns. The publications of analysts' forecasted may alter investor sentiment about the affected firms. Although the concept of return predictability has at times been controversial, the hypothesis is perfectly consistent with modern finance theory. Intertemporal asset pricing models illustrate the incentive of investors to hedge against future changes in the investment opportunity set, and hence consumption (Merton, 1973; Cox et al., 1985; Lucas, 1978; Breeden, 1979). To the extent that state variables co-vary with consumption and the investment opportunity set, there will be predictable components of returns. The more intriguing question is the degree of return predictability. The empirical finance literature employs a multitude of approaches to assess the economic significance of return predictability, yet for a variety of reasons, convincing conclusions remain elusive. Often, the significance of predictability is judged according to the t-statistics and -values of predictive regressions. However, statistical significance does not necessarily translate into economic significance. In addition, inferences drawn from predictive regressions can be unreliable when, as is often the case, predictors are stochastic and/or persistent. A different approach is to investigate the returns to trading strategies based on the predictability. Although the findings under this approach go further towards facilitating an economic interpretation of return predictability, deficiencies and pitfalls remain. One example is transaction costs. Before a finding of economically significant return predictability can be claimed, the effect of transaction costs on the returns to trading strategies must be accounted for. More importantly, research that investigates the economic significance of trading strategies must simulate the considerable uncertainty faced by an investor when selecting a predictive model ('model uncertainty'). There are many candidate variables that present themselves, and the investor must choose a subset of predictors with which stock returns are forecast and investment decisions enacted. In simulating this decision process, it is imperative to use information that is genuinely available to the investor at the time the decision is made, thus avoiding any potential look-ahead bias ('data snooping'). Cornell and Shapiro (1987) argue stakeholder theory in addition to the implied claims hypothesis. Under this hypothesis, the impact of new information on stock prices depends on the degree to which the new information is news to stakeholders (as divergent to only stockholders) along with on the amount of organizational capital (the value of all future implicit [stakeholder] claims that the firm expects to sell). The shock of the new news on the perception of inherent claim may be pretentious by the trustworthiness of the source of information. With stare to organizational resources, Cornell and Shapiro (1987 74) argue that non-standard returns are likely to be a decreasing function of firm size for the reason that the benefit of free publicity should not exceed the cost of directly disseminate the information. Barber and Loeffler (1993 147) have also examined the price pressure along with information hypothesis to explain stock price reaction to second-hand information. The price pressure hypothesis pose that analysts' recommendations create temporary buying pressure by naive investor which causes temporary abnormal returns. The information hypothesis poses that the analysts' recommendation reveals new material information that results in a basic revaluation of the security. They interpret their findings of an initial positive stock price reaction that partially reverse over the following month as hold up for both hypotheses. The Occam's Razor approach to the components of return echoes the philosophy of John Maynard Keynes, perhaps the most influential economist of the twentieth century. Keynes posited these sources of financial returns: Investment (which he called "enterprise"): "the activity of forecasting the prospective yield on the asset over its whole life assuming that the existing state of affairs will continue indefinitely." Speculation: "the activity of forecasting the psychology of the market attaching hopes to a favourable change in the conventional basis of valuation." In our Occam's Razor model, the combination of initial dividend yield and prospective 10-year earnings growth-the two investment fundamentals-is the analog for the Keynesian concept of enterprise-the estimated yield of the asset over its lifetime. The change in price-earnings ratios is the analog for speculation-a change in the basis of valuation, or a barometer of investor sentiment. Investors pay more for earnings when their expectations are high, and less when they lose faith in the future. When stocks are priced at a multiple of 21 times earnings (or higher), the mood is exuberance. At 7 times earnings, the mood approaches despair. After all, the price-earnings ratio simply represents the price paid for a dollar of earnings. But, as the valuation falls from 21 to 7 times earnings, prices fall by 67 percent. If the reverse occurs, prices increase by 200 percent. If there is no change in the price-earnings ratio, the total return on stocks depends almost entirely on the initial dividend yield and the rate of earnings growth. As demonstrated, investment, or enterprise, has prevailed over speculation in the long run. In the eight virtually consecutive decades from 1926 through 1997, the nominal initial dividend yield has averaged 4.5 percent, and earnings growth has averaged 4.2 percent. The sum of these two components is a fundamental stock return of 8.7 percent, slightly less than the 10.5 percent nominal return actually provided by stocks over the same rolling periods. We can chalk up the remaining 1.8 percent to speculation (or, more likely, to the imprecise nature of our analysis). * In short, the fundamentals of investment-dividends and earnings growth-are the right things to remember about things past. In the very long run, the role of speculation has proven to be a neutral factor in the shaping of returns. (Avery, 1999 500) Speculation cannot feed on itself forever. Periods in which speculation has enhanced returns have been followed by periods in which speculation has diminished returns. No matter how compelling-or even predominant-the impact of speculation on return is in the short run, expecting it to repeat itself leads our expectations down the wrong road. Speculation is the wrong thing to remember as we peer into the future to consider things yet to come. The point of this analytical exercise is pragmatic. If there are favourable odds of making reasonably accurate long-term projections of investment returns, and if fundamental returns-earnings and dividends-are the dominant force in shaping the long-term returns that actually transpire, would not a strategy focused on those fundamental factors be more likely to be successful than a strategy of speculation for the investor with a long-term time horizon Short-term investment strategies-which effectively ignore dividend yield and earnings growth, both of which are virtually inconsequential in a period of weeks or months-have almost nothing to do with investment. But they have a lot to do with speculation; that is, simply guessing at the price that other investors might be willing to pay for a diversified portfolio of stocks or bonds at some future time when we are willing to sell. Speculation is typically the only reason for the sometimes astonishing daily, weekly, or monthly swings we witness. But speculation can also play a major role in longer-term periods. In the 1980s, for example, stocks delivered a truly remarkable annual total return of 17.5 percent, virtually all of which was derived from an initial yield of 5.2 percent; earnings growth of 4.4 percent; and an annual valuation increase of 7.8 percent, as the price-earnings multiple more than doubled, from 7.3 to 15.5 times. The speculative element outweighed, by a wide margin, each of the fundamental elements, and came close to matching their combined contribution. (Bakshi, 2001 14) Speculative mania can also take a depressing turn. In the 1970s, stocks produced an average return of 5.9 percent, explained almost entirely by the initial yield of 3.4 percent, earnings growth of 9.9 percent, and a valuation decrease at an annual rate of -7.6 percent, as the price-earnings ratio dropped from 15.9 to 7.3 times. The market's loss of confidence exacted a heavy toll on the bounty generated by investment fundamentals. If the former extreme was a "Golden Decade," the latter could be called a "Tin Decade". It may not be entirely by accident that the total combined return for the two decades came to 11.5 percent. That figure is remarkably close to the fundamental return of 11.4 percent (an average 4.3 percent dividend yield plus average earnings growth of 7.1 percent); the price-earnings ratio fell slightly, from 15.9 percent to 15.5 percent, reducing return by just 0.1 percent annually. Together, the combined returns surely represent the "back to normalcy" nature that financial markets tend to exhibit. As the 1990s began, it has been reasoned that these long-term data could help provide a framework of expectations for the coming decade. It's known that the initial dividend yield on stocks on January 1, 1990, was 3.1 percent. It's needed only to project the other two variables: earnings growth and the change in the price-earnings ratio for the decade. For help in thinking through these forecasts. If the future earnings growth rate were 8 percent, and the price-earnings ratio were to ease downward from 15.5 times to a more traditional 14 times, the total return on stocks would approximate 10.3 percent per year. At the time this matrix was constructed, this earnings growth rate, relative to its past historical rate of 5.8 percent, was aggressive. The price-earnings ratio, while below the then-existing level, was above the historical norm. "Too low, " one might say. "The 1990s will be just like the 1980s." However, to get the remarkable 17 percent return achieved during the 1980s, given the initial dividend yield of about 3.1 percent, would take, among other combinations, a 9 percent earnings growth rate and an increase in the price-earnings multiple to 24 times. This seemed both an aggressive earnings projection and a multiple that had often signalled substantial overvaluation that had ultimately been corrected by a market decline. "Too high," another might say. "I expect 6 percent earnings growth and an earnings multiple of 12 times." Net result: An annual return of 6.8 percent-about two-thirds of the historical 10.3 percent norm, on assumptions that were far short of catastrophic. It could be explained that: Those who believe that the market's incredible momentum will be sustained, that the huge sustained purchases of stocks by individual investors will not slacken, and that we are indeed in a new era of global growth will hold the line in their equity allocation-or perhaps even increase it. But those who believe-as It's done that fundamentals such as earnings and dividends matter, and that, in the fullness of time, some semblance of historic norms will prevail, should consider at least some modest leaning against the powerful wind that is driving the high returns in this great bull market. And those who believe that another Great Crash lies around the corner must consider an even larger reduction of their equity exposures. Irrespective of what the future holds, however, it seems to me that equities should remain the investment of choice for the long-term investor-the dominant component of a well-balanced asset allocation program. So, invest with intelligence and common sense; engage in an enlightened and rational discourse when considering the future; always have some significant portion of your assets both in stocks and in bonds; be sparing about precipitate and extreme changes in these proportions. And be sceptical about every prognostication you are given, including mine. If you have set an intelligent route toward capital accumulation, stay the course-no matter what. With a bow to Occam's Razor and the role of simple concepts, For providing a better understanding of what is fundamental and what is transitory-what is investment and what is speculation-to help you come to a rational expectation of the range of returns that both stocks and bonds can provide over the long term. Now, we can get down to the most basic element of long-term investment strategy: the allocation of our investments between stocks and bonds. In the past 25 years, we have come to frame the simple logic of diversification in terms of a rigorous statistical model developed by finance academics: Modern Portfolio Theory. Investors almost universally accept this theory, which is based on developing investment portfolios that seek returns that optimize the investor's sentiment to assume risk. Risk, in turn, is defined in terms of short-term fluctuations in expected value. In its most comprehensive form, modern portfolio theory dictates that portfolio composition should include all liquid asset classes-not only U.S. stocks, bonds, and cash reserves, but international investments, short positions, foreign exchange, and various curios (gold, for example) from the financial marketplace. Such a range may be theoretically attractive, but the basic concept need not be so complex. Indeed, more than fourteen centuries ago, the Talmud prescribed this simple asset-allocation strategy: "A man should always keep his wealth in three forms: one third in real estate, another in merchandise, and the remainder in liquid assets." The advice is not much different from what is recommended in that ancient body of Jewish tradition and law. Rather than real estate and merchandise, however, the focus is on the marketable securities for an investment portfolio: stocks and bonds. For simplicity's sake, one can omit cash reserves such as money market funds from the equation. Because they tend to deliver very modest returns, such reserves should be considered as savings for short-term and emergency needs, not as investment for long-term capital accumulation. For investors, short-term bonds are a superior alternative to money market funds. Short-term bonds are relatively insensitive to interest rate fluctuations; long-term bonds are hugely sensitive. Most of the examples presented in this book are based on intermediate-term and long-term bonds. Like the Talmud's asset allocation advice, the guidelines are simple: as a crude starting point, two-thirds in stocks, one-third in bonds. Balance optimizes returns from the stock market in order to reach investment goals such as the accumulation of assets for retirement, but it holds the risk of loss to tolerable levels by ownership of some bonds, too. Despite (or perhaps because of) the long bull market in stocks that has made balanced investing seem old-fashioned and stodgy to some advisers, It could be continued to advocated a balanced policy today-with more enthusiasm than ever. The point of these examples is that the model sets the framework for a rational discourse on the returns on stocks in the 1990s. It makes it clear that, unless we have unusually optimistic sentiment that results in high price-earnings ratios in 1999 (indeed, why not), and earnings growth for the decade higher than that of any past decade (again, why not), stocks will have their work cut out for themselves to exceed returns in the 8 percent to 12 percent range during the 1990s, perhaps averaging 10 percent annually. Conclusion In this paper it is shown that changes in reported ratios can be used to predict future returns in stocks. The investment strategy suggested is to sort stocks based on the changes in reported EP ratios, and among the stocks with the largest decrease in reported ratio choose the ones with highest EP ratio. The cause of this predictive ability is most likely that investors over-react to new information, in particular earnings' information. However, this interpretation is contrary to the findings by Chari (1988) and Fama (1992) using different data, but the results are consistent. Whether the difference in interpretation is due to the different methodologies applied and/or to differences between U.S. and Canadian markets remains to be analyzed. Bibliography Arbel, A., and P. Strebel, "Pay Attention to Neglected Firms!" Journal of Portfolio Management, 9 (Winter 1983), pp. 37-42. Arbel, A., and P. Strebel, "The Neglected and Small Firm Effect," Financial Review, 17 (November 1982), pp. 201-218. Avery, C., Chevalier, J., 1999. Identifying investor sentiment from price paths: the case of football betting. Journal of Business 72, 493- 521. Bakshi, G., Chen, Z., 2001. Stock valuation in dynamic economies. Working Paper. Barber, B.M., 1994. Noise trading and prime and score premiums. Journal of Empirical Finance 1, 251-278. Barber, B.M., and D. Loeffler, "The 'Dartboard' Column: Second-Hand Information and Price Pressure," Journal of Financial and Quantitative Analysis, 28 (June 1993), pp. 273-284. Barberis, N., Shleifer, A., Vishny, R., 1998. A model of investor sentiment. Journal of Financial Economics 49, Bjerring, J.H., J. Lakonishok, and T. Vermaelen, "Stock Prices and Financial Analysts' Recommendations," Journal of Finance, 38 (March 1983), pp. 187-204. Black, F. "Noise," Journal of Finance, 41 (July 1986), pp. 529-542. Brown, S.J., and J.B. Warner, "Using Daily Stock Returns: The Case of Event Studies," Journal of Financial Economics, 14 (March 1985), pp. 3-32. Chari, V.V., Ravi Jagannathan, and Aharon R. Ofer, "Seasonalities in Security Returns: The Case of Earnings Announcements," Journal of Financial Economics, 21 (January/March 1988), pp. 101122. Copeland, T.E., and D. Mayers, "The Value Line Enigma (1965-1978): A Case Study of Performance Evaluation Issues," Journal of Financial Economics, 10 (November 1982), pp. 289-322. Cornell, B. and A.C. Shapiro, "Corporate Stakeholders and Corporate Finance," Financial Management, 16 (Spring 1987), pp. 5-14. Davies, P.L., and M. Canes, "Stock Prices and the Publication of Second-Hand Information," Journal of Business, 51 (January 1978), pp. 43-56. Dodd, P., and J.B. Warner, "On Corporate Governance" Journal of Financial Economics, 11 (April 1983), pp. 401-438. Fama, E.F., and K.R. French, "The Cross-Section of Expected Returns," Journal of Finance, 47 (June 1992), pp. 427-465. Glascock, J.L., G.V. Henderson, and L.J. Martin, "When E.F. Hutton Talks ... ," Financial Analysts Journal, 42 (May-June 1986), pp. 69-72. Grant, E.B., "Market Implications of Differential Amounts of Interim Information," Journal of Accounting Research, 18 (1980), pp. 255-268. John C. Bogle, "The 1990s at the Halfway Mark, " The Journal of Portfolio Management (Summer 1995), pp. 21-31. Lease, R.C., and W.G. Lewellen. "Market Efficiency Across Securities Exchanges," Journal of Economics and Business, 34 (1982), pp. 101-109. Lee, C.J., "Information Content of Financial Columns," Journal of Economics and Business, 38 (1986), pp. 27-29. Liu, P., S.D. Smith, and A.A. Syed, "Stock Price Reactions to The Wall Street Journal's Securities Recommendations," Journal of Financial and Quantitative Analysis, 25 (September 1990), pp. 399410. Lloyd-Davies, P., and M. Canes, "Stock Prices and the Publication of Second-Hand Information," Journal of Business, 51 (January 1978), pp. 43-56. Mikkelson, W.H., and M.M. Partch, "Withdrawn Security Offerings," Journal of Financial and Quantitative Analysis, 23 (June 1988), pp. 119-133. Pari, R.A., "Wall Street Week Recommendations: Yes or No" Journal of Portfolio Management, 14 (Fall 1987), pp. 74-76. Peter L. Bernstein and Robert Arnott, "Bull Market Bear Market Should You Really Care" The Journal of Portfolio Management (Fall 1997), pp. 26-29. Shleifer, A., and L.H. Summers, "The Noise Trader Approach to Finance," Journal of Economic Perspectives, 4 (Spring 1990), pp. 19-33. Stickel, S., "The Effect of Value Line Investment Rank Changes on Common Stock Prices," Journal of Financial Economics, 14 (March 1985), pp. 121-143. Read More