Academics have struggled to identify risk factors that can explain momentum premiums. By contrast, behavioral arguments seem to have had more success. The behavioral story is that momentum is due to investors’ under-reaction to an ongoing flow of new information, such as earnings releases and analyst recommendations. Behavioralists also argue that investors sell winners too early and hold losers too long. While these explanations have been embraced by some academics and practitioners, they share a common theme — they relate to the behavior of investors. This paper provides an alternative explanation for momentum that is more focused on sell-side analyst behavior.
The authors provide evidence that analyst behavior also plays an important rule in momentum profits. In this view, it is not only behaviorally-challenged investors who drive the momentum effect — it’s also behaviorally-challenged analysts! The authors hypothesize that higher analyst optimism is associated with higher subsequent momentum returns.
So How Does Optimism Lead to Profits?
The authors want to answer a simple question: Is higher analyst optimism associated with higher subsequent momentum profits? The authors use a sample that includes stock recommendations from the Thomson Financial Institutional Brokers’ Estimate System (IBES) database from the 3rd quarter of 1993 to the 1st quarter of 2011. These recommendations were posted on popular financial websites such as Yahoo Finance, MSN money, Market Watch, and Morningstar. Thus, investors had easy access to them.
For any quarter, the authors examine stocks that receive at least one recommendation; these are “covered stocks.” For each covered stock, the authors create a “consensus recommendation,” which averages the analyst recommendations over the trailing four quarters at the end of each quarter. The covered stocks are then sorted into five ordered categories: strong buy = 5; buy = 4; hold = 3; sell = 2; and strong sell = 1. These categories form quintiles, denoted in columns in the tables below as “Rec 1,” “Rec 2,” etc.
Next, the authors sorted each recommendation quintile by prior 6-month returns. Consistent with prior research by Jegadeesh et al. (2004), they find that analyst recommendations are related to prior stock returns. For example, note in the table below how stocks with high prior 6-month returns (“Past Ret 5 (high)”) are more likely to receive a strong recommendation (5.16% of total recommendations) than to receive a low recommendation (at 2.17% of total recommendations).
Thus, analysts seem more likely to give high recommendations to stocks that have done well in the recent past. Conversely, they also tend to give lower recommendations to stocks that have done poorly in the recent past.
But what happens going forward? Are these recommendations predictive? If these analyst recommendations had no effect on subsequent returns, then we would expect to observe that the recommendations have no relationship to future performance of stocks within a given past return quintile. Is this what we find? No.
As hypothesized, the results show that:
- Higher analyst optimism is associated with higher subsequent momentum profits.
Consider “Past Ret 5” in Panel B (below); this row shows that subsequent momentum profits, double sorted based on past high returns, generally rise with recommendation optimism, from -0.002 (low recommendation), to 0.057, (high recommendation). In fact, the analysts seem to be driving subsequent momentum profits within each quintile of past returns (although the effect is strongest for stocks with the highest past returns). The 6-month momentum strategy profits equal 3.1% for the low recommendation quintile and 5.5% for the high recommendation quintile. The authors conclude that analyst sentiment fuels momentum!
The double sorts are the easiest analysis to understand, however, they fail to control for other factors that might explain the results. To address these concerns the authors conduct a battery of regressions and come to the same conclusion: analyst recommendations are related to future momentum profits.
Interesting stuff…Yes, Optimism can Lead to Higher Returns was originally posted at Alpha Architect. Please read the Alpha Architect Disclosures at your convenience.
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