- "Cross-Firm Information Flows and the Predictability of Stock Returns" (with Bernd Schlusche)
We identify leader stocks based on their ability to Granger-cause returns of other stocks and show that thus-identified leaders can reliably predict their followers' returns out of sample. Leaders' predictive ability is robust to firm- and industry-level controls and works at the level of individual stocks rather than industries. Many leaders cannot be easily detected using ex-ante firm characteristics: They are often small, belong to a different industry than their followers, and exhibit only a short-lived leadership. We find support for the conjecture that leaders tend to be at the center of important news developments that also affect their followers by showing that, all else equal, firms with greater news coverage have a larger number of followers. We furthermore find that, consistent with the view that equilibrium mispricing is related to arbitrage costs, more heavily traded stocks react to their leaders' signals with a shorter delay. Finally, we present evidence that sophisticated investors trade on leaders' signals.
- "Economic Linkages Inferred from News Stories and the Predictability of Stock Returns" (with Bernd Schlusche)
In this paper, we provide evidence that news stories reveal soft information about economic linkages between firms that is not immediately incorporated into stock prices. Specifically, we check which stock pairs were mentioned together in the same story in the Thompson-Reuters News Analytics dataset over a pre-specified rolling window and show that the average return of the group of stocks that are linked to a given stock by common news coverage predicts that stock's return for the subsequent day, week and month. Similarly, the current return of a stock predicts future returns of its linked stocks. Cross-predictability of returns increases with the number of common news stories. Our results are robust to various firm and industry factors that are known to predict returns. The delayed price reaction to linked-firm returns is consistent with slow processing of complex information.
- "Unusual News Events and the Cross-Section of Stock Returns" (with Turan G. Bali, Andriy Bodnaruk, and Yi Tang), Management Science, forthcoming
We document that stocks that experience sudden increases in idiosyncratic volatility underperform otherwise similar stocks in the future, and we propose that this phenomenon can be explained by the Miller (1977) conjecture. We show that volatility shocks can be traced to the unusual firm-level news flow, which temporarily increases the level of investor disagreement about the firm value. At the same time, volatility shocks pose a barrier to short selling, preventing pessimistic investors from expressing their views. In the presence of divergent opinions and short selling constraints, prices end up initially reflecting optimistic views but adjust down in the future as investors' opinions converge.
- "Asset Price Bubbles: A Survey" (with Bernd Schlusche), Quantitative Finance, Vol. 14, No. 4, pp. 589-604, 2014.
Why do asset price bubbles continue to appear in various
markets? What types of events give rise to bubbles and why do
arbitrage forces fail to quickly burst them? Do bubbles have real
economic consequences and should policy makers do more to prevent
them? This paper provides an overview of recent literature on
bubbles, with significant attention given to behavioral models and
rational models with frictions. The latest U.S. real estate bubble
is described in the context of this literature.
- "Market Reaction to Corporate Press Releases" (with Andreas Neuhierl and Bernd Schlusche), Journal of Financial and Quantitative Analysis, Vol. 48, No. 4, pp. 1207-1240, 2013.
We classify a unique and comprehensive dataset of corporate press releases into topics and study the market reaction to various types of news. While confirming prior findings regarding strong stock price responses to financial news, we also document significant reactions to news about corporate strategy, customers and partners, products and services, management changes, and legal developments. Consistent with regulators' expectations, the level of informational asymmetry in the market declines following most types of press releases. At the same time, return volatility frequently increases in the post-announcement period, which we show can be attributed to higher levels of valuation uncertainty.
- "Inheriting Losers" (with Li Jin) Review of Financial Studies, Vol. 24, No. 3, pp. 786-820, 2011.
We show that new managers who take over mutual fund portfolios typically proceed to sell off inherited momentum losers. They sell losers at higher rates than stocks in any other momentum decile, even after adjusting for concurrent trades in these stocks by continuing fund managers. This behavior persists even when managers take over well-performing funds and funds with positive fund flows where it is unlikely that they are expected to change fund strategy or sell holdings to meet redemption demand. We conjecture that continuing fund managers tend to hold on to losers because of their inability to ignore the sunk costs associated with the stocks' past underperformance. Furthermore, we present evidence that the sell-off creates price pressure in the market by showing that the losers inherited in high quantities by new managers experience negative abnormal returns in up to two weeks following the completion of managerial change.
- "Mispricing and Costly Arbitrage" (with Ronnie Sadka) Journal of Investment Management, Vol. 7, No. 4, pp. 1-13, 2009.
The equilibrium magnitude of mispricing can be no greater than the cost of arbitraging it away. Yet, mispricing typically arises when the uncertainty about a firm is high, which is precisely when the stock's liquidity is low. This is the case for stocks with high analyst disagreement about future earnings. These stocks tend to be overpriced, with prices converging down as the uncertainty about earnings is resolved, but the stocks' low liquidity suggests that transaction costs significantly reduce the potential arbitrage profits. Positive shocks to market-wide liquidity reduce arbitrage costs and accelerate the convergence of prices to fundamentals.
- "Suppressed Negative Information and Future Underperformance" Review of Finance, Vol. 12, No. 3, pp. 533-565, 2008.
I present evidence of inefficient information processing in equity markets by documenting that negative information withheld by securities analysts is incorporated in stock prices with a significant delay. I estimate the extent of the withheld negative information based on the proportion of analysts who stop revising their annual earnings forecasts. This measure predicts negative earnings surprises and negative price reaction around earnings announcements. It could also be used to generate profitable trading strategies. I show that institutions tend to sell their stock holdings as my measure of unreported negative news increases, thus ameliorating the mispricing.
- "Analyst Disagreement, Mispricing and Liquidity" (with Ronnie Sadka) Journal of Finance, Vol. 62, No. 5, pp. 2367-2403, 2007.
This paper documents a close link between mispricing and liquidity by investigating stocks with high analyst disagreement. Previous research finds that these stocks tend to be overpriced, but that prices correct downwards as uncertainty about earnings is resolved. Our analysis suggests that one reason mispricing has persisted through the years is that analyst disagreement coincides with high trading costs. We also show that in the cross-section, the less liquid stocks tend to be more severely overpriced. Additionally, increases in aggregate market liquidity accelerate the convergence of prices to fundamentals. As a result, returns of the initially overpriced stocks are negatively correlated with the time series of innovations in aggregate market liquidity.
- "Differences of Opinion and the Cross-Section of Stock Returns" (with Karl Diether and Chris Malloy) Journal of Finance, Vol. 57, No.5, pp. 2113-2141, 2002.
We provide evidence that stocks with higher dispersion in analysts' earnings forecasts earn lower future returns than otherwise similar stocks. This effect is most pronounced in small stocks and stocks that have performed poorly over the past year. Interpreting dispersion in analysts' forecasts as a proxy for differences in opinion about a stock, we show that this evidence is consistent with the hypothesis that prices will reflect the optimistic view whenever investors with the lowest valuations do not trade. By contrast, our evidence is inconsistent with a view that dispersion in analysts' forecasts proxies for risk.
- "The Declining U.S. Equity Premium" (with Ravi Jagannathan and Ellen McGrattan) Federal Reserve Bank of Minneapolis Quarterly Review, Vol. 24, No. 4, pp. 3-19, 2000.
This study demonstrates that the U.S. equity premium has declined significantly during the last three decades. The study calculates the equity premium using a variation of a formula in the classic Gordon stock valuation model. The calculation includes the bond yield, the stock dividend yield, and the expected dividend growth rate, which in this formulation can change over time. The study calculates the premium for several measures of the aggregate U.S. stock portfolio and several assumptions about bond yields and stock dividends and gets basically the same result. The premium averaged about 7 percentage points during 1926-70 and only about 0.7 of a percentage point after that. This result is shown to be reasonable by demonstrating the roughly equal returns that investments in stocks and consol bonds of the same duration would have earned between 1982 and 1999, years when the equity premium is estimated to have been zero.
- "Real Estate Prices During the Roaring Twenties and the Great Depression" (with Tom Nicholas) Real Estate Economics, Vol. 41, No. 2, pp. 278-309, 2013.
Using new data on market-based
transactions we construct real estate price indexes for Manhattan
between 1920 and 1939. During the 1920s prices reached their
highest level in the third quarter of 1929 before falling by 67
percent at the end of 1932 and hovering around that value for most
of the Great Depression. The value of high-end properties strongly
co-moved with the stock market between 1929 and 1932. A typical
property bought in 1920 would have retained only 56 percent of its
initial value in nominal terms two decades later. An investment in
the stock market index (including dividends) would have
outperformed an investment in a typical property (including net
rental income), by a factor of 5.2 over our time period.
- "Asset Bubbles: An Application to Residential Real Estate" (with Bernd Schlusche) European Financial Management, Vol. 18, No. 3, pp. 464-491, 2012.
Behavioral models offer new insights into why bubbles are ubiquitous in residential real estate markets. These markets are dominated by unsophisticated households who often develop optimistic views by extrapolating from past returns. Rational investors cannot easily trade against an overvaluation of housing assets because of high transaction costs and a binding short sale constraint. Circumventing the effect of the latter, the supply of housing frequently increases in response to rising prices. This helps to mitigate bubbles but often leads to overbuilding, which slows down the recovery after a bubble bursts. Models that incorporate the effects of perverse incentives and limits to arbitrage are especially helpful in explaining the bubble that developed in mortgage-backed securities and helped fuel the recent real estate bubble by relaxing home buyers' borrowing constraints. The literature is ambiguous about whether governments should intervene to burst bubbles, as a better response may lie in improving incentives of key market players.