Investor Sentiment and Stock Prices: Explaining the Ups and Downs
Academics, traders and money managers are forever trying to figure out what makes stocks rise and fall. Some influences are clear, like the price gain after a company reports surprisingly strong earnings. But as experts drill deeper, other behaviors are mystifying. Why do shares of companies with fast asset growth sometimes do better than expected according to standard measures like earnings? And why do they sometimes do worse? What explains the price patterns of stocks that share special features like return on assets, rates of total accruals and rates of net stock issues?
For years, two theories have tried to explain such anomalies in stock returns. The first says that investors may have reached a keen understanding of hard-to-detect risks associated with these special features. If so, unusually large price gains would reflect a risk premium -- a larger gain to compensate for larger risks.
The second theory suggests that these unexpected gains and losses are a result of mispricing -- that is, when investors, for some reason, pay too much or too little for a stock relative to the stock's underlying fundamentals.
Now, new research by Wharton finance professor Robert F. Stambaugh and two colleagues has unearthed strong evidence for the mispricing theory, discovering that market-wide investor sentiment is a key influence. "Our study looks at investor sentiment as a potentially important source of mispricing," Stambaugh says. "In other words, when investor sentiment is high, do things get overpriced? And if they do, can we see evidence of that influence?"
Stambaugh and his colleagues -- Yu Yuan, a visiting professor at Wharton, and Jianfeng Yu of the Carlson School of Management at the University of Minnesota -- identified 11 features associated with stock price changes that defy easy explanation. One of these features (which the researchers refer to as "anomalies" in their paper) is a company's growth in assets like plant equipment, fleets of vehicles, property and inventories -- anything on the asset side of the balance sheet. Others include firms in financial distress, firms that issue new shares of stock, those with high accruals and those showing share-price momentum, as well as firms with gross profitability premium, and those distinguished by their return on assets and the ratio of investments to assets.
For instance, "companies that have grown their assets the most do, on average, produce lower subsequent returns on their stock, which presents a bit of a puzzle," Stambaugh says. If the risk-based theory were true, companies with high rates of asset growth must be seen by investors as less risky than companies with low rates of asset growth. Investors would therefore settle for lower returns -- a view that then is reflected in price changes.
But there is no obvious reason for investors to regard such firms as less risky, Stambaugh points out. "What gets this thing called an anomaly to begin with is that previous attempts by others to try to attribute these [price changes] to risks have not been successful."
If risk is not the explanation, "the obvious alternative is that somehow the market misprices these things." One potential cause? Investor sentiment -- a mood -- carries these stock prices up or down to a degree that cannot be explained by fundamentals like earnings and revenues.
Barriers to Short Selling
To examine this possibility, Stambaugh and his colleagues combined two concepts that researchers have investigated separately. "The first concept is that investor sentiment contains a market-wide component with the potential to influence prices on many securities in the same direction at the same time," they write in their paper, "The Short of It: Investor Sentiment and Anomalies," which was published in the May issue of the Journal of Financial Economics. This is what happens during bubbles, when investor exuberance pushes prices above the levels that can be justified by standard measures of value. A bust often follows, as pessimism drags prices too far down.
The second concept, according to the researchers, "is that impediments to short selling play a significant role in limiting the ability of rational traders to exploit overpricing." "It is not as easy to short as it is to go out and buy a stock," Stambaugh notes....MORE