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Europian MOM Strategy

Europian MOM Strategy

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European Momentum Strategies, Information Diffusion, and Investor
Conservatism
John A. Doukas and Phillip J. McKnight*
February 12, 2003
Abstract

In this paper we conduct an out-of-sample test of two behavioral theories that have been proposed to explain momentum in stock returns. We test the gradual-information-diffusion model of Hong and Stein (1999) and the investor conservatism bias model of Barberis, Shleifer and Vishny (1998) in a sample of 13 European stock markets during the period 1988 to 2001. These two models predict that momentum comes from the (i) gradual dissemination of firm-specific information and (ii) investors\u2019 failure to update their beliefs sufficiently when they observe new public information. The findings of this study are consistent with the predictions of the behavioral models of Hong and Stein\u2019s (1999) and Barberis et al. (1998). The evidence shows that momentum is the result of the gradual diffusion of private information and investors\u2019 psychological conservatism reflected on the systematic errors they make in forming earnings expectations by not updating them adequately relative to their prior beliefs and by undervaluing the statistical weight of new information.

*Department of Finance, Stern School of Business, New York University, 44 West 4th Street, New York, NY 10012, Tel:(212) 998-0432, Fax:(212) 994-422, E-mail:jdoukas@stern.nyu.edu, Department of Accounting and Finance, Cardiff Business School, Cardiff, UK CF10 3EU, Tel: 02920 876804, Fax: 02920 876804 E-mailm c k n i g h t p j @ c a r d i f f . a c . u k, respectively.

We are grateful for the financial support provided by INQUIRE, EUROPE and The Leverhulme Trust. The authors also gratefully acknowledge the contribution of Thomson Financial for providing earnings per share forecast data, available through the Institutional Brokers Estimate System I/B/E/S. This data has been provided as part of a broad academic program to encourage earnings expectations research.

1
European Momentum Strategies, Information Diffusion, and Investor
Conservatism

Several recent papers have shown that stock returns are related to past performance-that is, past losers tend to be future winners and past winners are future losers. Jagadeesh and Titman (1993, 2001), and Asness (1994), using U. S. samples of stocks, find that when portfolios are formed over a short-term (from three months to a year) horizon, stock returns performance persists. A strategy that buys past six-month winners (stocks in the top performance decile) and shorts past six-month losers (stocks in the bottom performance decile) earns approximately one percent per month. Rouwnehorst (1998) finds stock return momentum in a sample of 12 European countries over the 1980-1995 period.1 While there has been considerable evidence in support of momentum in stock returns it remains unclear whether the medium-term continuation pattern in stock returns reflects risk or market\u2019s improper response to information. Conrad and Kaul (1998), for instance, suggest a risk- based explanation. Fama and French (1996), however, show that their three-factor model fails to explain this return pattern. The seminal work of Ball and Brown (1968), and more recent evidence by Chan, Jagadeesh, and Lakonishok (1996), suggest that momentum is a symptom of underreaction.2 That is, prices adjust slowly to new information.

More recently, several non-risk based theories have been developed to explain momentum in stock returns. The model of Barberis, Shleifer, and Vishny (1998) shows that momentum is rooted in investors\u2019 conservatism bias, and that investors do not update their beliefs adequately based on the strength and weight of new information. That is, investors place more emphasis on the strength of the information than on its statistical weight, relative to a rational Bayesian. Hong and Stein (1999) attribute momentum to the gradual diffusion of firm-specific information and the inability of investors to extract each other's private information from prices.3 Hong, Lim, and Stein (2000), test the gradual diffusion of firm-specific information hypothesis of Hong and Stein (1999), using U.S. stock returns.

1 Momentum strategies are also found to earn significant gains in emerging markets (Rouwenhorst (1997)).
2 There is some evidence that tax-loss selling creates seasonal variation in the momentum effect (Grinblatt and
Moskowitz (1999)), but Roll (1983) refers to such explanations as \u201cstupid\u201d because investors would have to be stupid
not to buy in December and sell in January at higher prices.
3Other non-risk based theories that produce momentum include the positive-feedback-trader model of Delong et al.
(1990) and the overconfidence model of Daniel, Hirshleifer, and Subrahanyam (1998).
2

Consistent with the hypothesis that firm-specific information spreads gradually across investors, they find that momentum strategies work better for stocks with low analyst coverage. They also find that (i) the profitability of momentum strategies is inversely related to firm size and (ii) the effect of analyst coverage is greater for stocks that are past losers than for past winners. In these two models (Barberis et al. (1998) and Hong and Stein (1999)), momentum is due to initial underreaction followed by a correction. Unlike other behavioral models, the common feature in the momentum explanations of Barberis et al. (1998) and Hong and Stein (1999) is that stock price underreaction is the outcome of insufficient investor reaction due to (i) conservatism behavior and (ii) slow diffusion of information, respectively. Conservatism means that investors react insufficiently, pushing prices up too little.

In this paper, we empirically examine these two models of momentum. The first objective of this paper is to test the Hong and Stein (1999) version of the underreaction hypothesis by studying return patterns in an international context. Specifically, we investigate whether momentum reflects the gradual diffusion of firm-specific information using residual analyst coverage as a proxy for the rate of information diffusion.4 While Hong, Lim, and Stein (2000), provide evidence in support of the idea that momentum strategies work better in low-analyst-coverage stocks, it cannot be ruled out that this result is limited to the U.S market. Without testing the robustness of these findings outside the environment in which they were found, it is difficult to determine whether these empirical results are merely spurious correlations that they may not be confirmed across capital markets. This paper fills a gap in the literature in this respect. Using international data over the period January 1988 to January 2001, we expect to shed more light on whether momentum strategies continue to be profitable and overcomes the criticism that observed empirical regularities arise from data mining. The second goal of this study is to investigate whether momentum is consistent with the model of Barberis et al. (1998) implying that investors exhibit conservatism and underreact to information that has a high weight when adjusting their beliefs.5 We use the dispersion in analyst forecasts as a proxy for the weight of information. It follows that a consensus forecast revision (i.e., strength of information) with low

4Hong, Lim, and Stein (2000) use residual analyst coverage to proxy for the rate of information diffusion as well.
5 The Barberis, Shleifer, and Vishny (1998) theory builds on Griffin and Tversky\u2019s (1992) seminal work on the

weighing of evidence and formation of beliefs in human thought. Edwards (1968) provides evidence consistent with the view that individuals are conservative in the sense that they do not adjust their beliefs sufficiently. That is, the adjustment process of updating human beliefs does not adequately take into account thew e i g h t of new information.

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