Why are hot stocks like boiling frogs?
Around 1997, academics began paying closer attention to the "momentum factor" of stocks: the tendency of hot stocks to continue climbing and cold stocks to continue declining. Like size and value effects, the existence of momentum has been well documented, and studies have been trying to identify the source (either behavior or risk) of the momentum premium. A new study takes the "frog-in-the-pan" approach to try to explain momentum.
According to the frog-in-the-pan anecdote, a frog will jump out of a pan containing boiling water since the dramatic temperature change induces an immediate reaction. However, if the water in the pan is slowly raised to a boil, the frog will underreact and perish. (And yes, I understand this tale is actually false.)
When it comes to humans, there's evidence that we react differently to a series of small, gradual changes from the way we do to large, dramatic ones, even when these changes have the same cumulative impact. For example, consumers perceive small, continuous price increases differently from one-time price increases. This is why companies tend to raise prices slowly but slash them in dramatic fashion. This behavior is explained by "limited attention," which can also be used to explain large inflows into mutual funds with extraordinarily high recent returns.
Current limited-attention literature implicitly assumes that investors can only process so much information at once. For example, the effect of earnings announcements seem to last longer following days with a large number of earnings announcements -- investors are overwhelmed by the large amounts of information released on these days. If investors react differently to a persistent stream of information than they do to discrete bits of information, this would provide a behavioral explanation for momentum.
The authors of the paper, "Frog in the Pan: Continuous Information and Momentum," argue that investors underreact to information that arrives continuously in small amounts. In fact, they found that the momentum profit following continuous information persists for eight months, while the momentum profit following discrete information is insignificant after two months.
They also found that forecast errors by security analysts are larger following continuous information; it fails to attract analyst attention, and that affects asset prices, inducing strong and persistent momentum. The researchers found that over a six-month holding period, the momentum effect decreases from 8.9 percent for stocks with continuous information during their formation period to 2.9 percent for stocks with discrete information but similar cumulative formation-period returns.
Finally, higher media coverage follows discrete information, while higher analyst coverage is associated with continuous information. Also, management press releases coincide with continuous good information -- they tend to release good information as soon as it's available, but delay the release of bad news.