How investor sentiment causes stock mispricing
Earlier this week, we examined the role investor sentiment played in Facebook's early days of trading and the effect it had on funds holding the stock. It begs the question: Does investor sentiment (the psychology of crowds) affect stock prices, leading to mispricings? The argument against this belief is that any effects caused by sentiment should, in theory, be eliminated by rational traders seeking to exploit the profit opportunities created by mispricings. However, if there are limits to arbitrage, rational traders can't fully exploit such opportunities -- and sentiment effects become more likely.
The authors of the study "The Short of It: Investor Sentiment and Anomalies," investigated the presence of sentiment effects by combining two concepts that are prominent in the academic literature:
- Investor sentiment contains a market-wide component with the potential to influence prices on many securities in the same direction at the same time.
- Impediments to short selling play a significant role in limiting the ability of rational traders to exploit overpricing.
They explored whether sentiment-related overpricing is at least a partial explanation for asset-pricing anomalies:
- Financial distress -- firms with high failure probability have lower, not higher, subsequent returns
- Net stock issuance -- issuers underperform non-issuers
- Accruals -- firms with high accruals earn abnormally lower returns on average than firms with low accruals
- Net operating assets -- defined as the difference on the balance sheet between all operating assets and all operating liabilities scaled by total assets, is a strong negative predictor of long-run stock returns
- Momentum -- high past recent returns forecast high future returns
- Gross profitability premium -- more profitable firms have higher returns than less profitable ones
- Asset growth -- companies that grow their total assets more earn lower subsequent returns
- Return on assets -- more profitable firms have higher expected returns than less profitable firms
- Investment-to-assets -- higher past investment predicts abnormally lower future returns
The authors hypothesized that the most optimistic investors are more likely to be too optimistic when investor sentiment is high than when it's low. Examples of investor sentiment being high are the 1968-69 electronics bubble, the biotech bubble of the early 1980s and the dotcom bubble of the late 1990s. Sentiment fell sharply after the 1961 crash of growth stocks, in the mid 1970s with the oil embargo, and of course in the crash of 2008. As the measure of sentiment, they used a composite index that includes six measures:
- The closed-end fund discount
- The number of IPOs
- The first-day returns of IPOs
- New York Stock Exchange turnover
- The equity share in total new issues
- The dividend premium, or the difference between the average market-to-book ratio of dividend payers and non-payers
For each of these anomalies, the authors analyzed the strategy that goes long the stocks in the highest-performing decile and short those in the lowest-performing decile. The following is a summary of their findings:
- Each of the 11 anomalies was stronger following higher-than-median levels of investor sentiment. Ten of the 11 results were statistically significant at the 5 percent level. (There was a 5 percent or less chance the results were random.)
- When averaged across anomalies, 70 percent of the benchmark-adjusted profits from a long-short strategy occurred in months following levels of investor sentiment above its median value.
- When averaged across anomalies, 78 percent of the benchmark-adjusted profits from shorting that leg occur in months following high sentiment.
- As expected, there was little evidence of overpricing in the long leg of the portfolio. The reason is that when market-wide sentiment is high, the stocks in the long leg could be overpriced, but the long leg should contain the least degree of overpricing. None of the 11 long legs exhibited a significant difference (an average of just 0.04 percent per month) between high- and low-sentiment periods.
The authors cited other works that support their findings:
- The 2006 study "Investor Sentiment and the Cross-Section of Stock Returns" found that market-wide sentiment exerted stronger impacts on stocks that are difficult to value and hard to arbitrage.
- The 2011 study "Investor Sentiment and the Mean-Variance Relation" found that the correlation between the market's expected return and its conditional volatility is positive during low-sentiment periods and nearly flat during high-sentiment periods -- the market is less rational during high-sentiment periods, due to higher participation by "noise" traders in such periods.
Given that the anomalies are well known -- they're challenges to the efficient market hypothesis -- why do they persist?
Limits to Arbitrage
Anomalies can persist when there are limits to arbitrage:
- Many institutional investors -- such as pension plans, endowments and mutual funds -- are prohibited by their charters from taking short positions.
- Shorting can be expensive -- you have to borrow a stock to go short, and many stocks are costly to borrow because there are low supplies of available stock from institutional investors.
- Investors are unwilling to accept the risks of shorting because of the potential for unlimited losses. Even traders who believe that a stock's price is too high know that they can be correct (the price may eventually fall), but face the risk that the price will go up before it goes down. Such a price move, requiring additional capital, can force the traders to liquidate at a loss. Long-only investors don't face this risk. The risk aversion is so high that the study "All That Glitters: The Effect of Attention and News on the Buying Behavior of Individual and Institutional Investors" found that only 0.29 percent of positions of individual investors are short positions.
The bottom line is that because of these impediments to short selling, overpricing becomes more difficult to eliminate. The authors concluded that overpricing should be more prevalent than underpricing given these short-sale impediments: "Investors with the most optimistic views about a stock, relative to the views of other investors, exert the greatest effect on the stock's price, because their views are not counterbalanced by the valuations of the relatively less optimistic investors. The latter investors are inclined to take no position if they view the stock as undervalued, rather than take a short position. When the most optimistic investors are too optimistic and overvalue the stock, overpricing results. In contrast, underpricing is less likely. As long as the cross section of views includes the view of rational investors, the most optimistic investors do not undervalue the stock."
The lesson for investors is to avoid being a noise trader. Don't get caught up in following the herd over the investment cliff. Stop paying attention to the prognostications of the financial media. And, most of all, have a well-developed, written investment plan and have the discipline to stick to it, rebalancing when needed, and harvesting losses as opportunities present themselves.
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