Behavioral Economics.

The NBER's Working Group on Behavioral Economics met in Cambridge on November 11. NBER Research Associates and Group Directors Robert J. Shiller of Yale University and Richard H. Thaler, University of Chicago, organized this program:

Am Tal Fishman and Harrison Hong, Princeton University, and Jeffrey D. Kubik, Syracuse University, "Do Arbitrageurs Amplify Economic Shocks?"

Discussant: Michael Rashes, Bracebridge Capital

John Y. Campbell, Harvard University and NBER, and Jens Hilscher and Jan Szilagyi, Harvard University, "In Search of Distress Risk" (NBER Working Paper No. 12362)

Discussant: Tyler Shumway, University of Michigan 

Andrea Frazzini, University of Chicago, and Owen Lamont, Yale University and NBER, "The Earnings Announcement Premium and Trading Volume"

Discussant: Steven Heston, University of Maryland 

David Hirshleifer and Slew Hong Teoh, University of California, Irvine, and Sonya Seongyeon Lim, DePaul University, "Driven to Distraction: Extraneous Events and Underreaction to Earnings News"

Discussant: Stefano Della Vigna, University of California, Berkeley and NBER

Robin Greenwood, Harvard University, and Stefan Nagel, Stanford University and NBER, "Inexperienced Investors and Speculative Bubbles"

Discussant: Jeremy C. Stein, Harvard University and NBER

Massimo Massa and Lei Zhang, INSEAD, "Cosmetic Mergers: The Effect of Style Investing on the Market for Corporate Control"

Discussant: Malcolm Baker, Harvard University and NBER

Fishman, Hong, and Kubik consider whether arbitrageurs amplify fundamental shocks in the context of short arbitrage in equity markets. The ability of arbitrageurs to hold on to short positions depends on asset values: shorts are often reduced following good news about a stock. As a result, the prices of highly shorted stocks are excessively sensitive to economic shocks. Using monthly short interest data and exploiting differences in short selling regulations across stock exchanges to instrument for the amount of shorting in a stock, the authors find: 1) The price of a highly shorted stock is more sensitive to earnings news than a stock with little short interest. 2) Short interest changes around announcements (proxied by share turnover) are more sensitive to earnings surprises for highly shorted stocks. 3) For highly shorted stocks, returns to shorting are higher following better earnings news. 4) These differential sensitivities are driven by very good earnings news as opposed to very bad earnings news. These findings point to the importance of limited arbitrage in affecting asset price dynamics and the potentially destabilizing role of speculators.

Campbell, Hilscher, and Szilagyi explore the determinants of corporate failure and the pricing of financially distressed stocks using U.S. data for 1963-2003. Firms with higher leverage, lower profitability, lower market capitalization, lower past stock returns, more volatile past stock returns, lower cash holdings, higher market-book ratios, and lower prices per share are more likely to file for bankruptcy, be de-listed, or receive a D rating. When predicting failure at longer horizons, the most persistent firm characteristics--market capitalization, the market-book ratio, and equity volatility--become relatively more significant. The model here captures much of the time variation in the aggregate failure rate. Since 1981, financially distressed stocks have delivered anomalously low returns. They have lower returns but much higher standard deviations, market betas, and loadings on value and small-cap risk factors than stocks with a low risk of failure. These patterns hold in all size quintiles but are particularly strong in smaller stocks. They are inconsistent with the conjecture that the value and size effects are compensation for the risk of financial distress.

On average, stock prices rise around scheduled earnings announcement dates. Frazzini and Lamont show that this earnings announcement premium is large, robust, and strongly related to the fact that volume surges around announcement dates. Stocks with high past announcement period volume earn the highest announcement premium, suggesting some common underlying cause for both volume and the premium. The authors show that high premium stocks experience the highest levels of imputed small investor buying, suggesting that the premium is driven by buying by small investors when the announcement catches their attention.

Psychological evidence indicates that it is hard to process multiple stimuli and perform multiple tasks at the same time. Hirshleifer and his coauthors test the investor distraction hypothesis, which holds that the arrival of extraneous news causes trading and market prices to react sluggishly to relevant news about a firm. They focus on the competition for investor attention between a firm's earnings announcements and the earnings announcements of other firms. They find that the immediate stock price and volume reaction to a firm's earnings surprise is weaker, and post-earnings announcement drift is stronger, when a greater number of earnings announcements by other firms are made on the same day. A trading strategy that exploits post-earnings announcement drift is most profitable for earnings announcements made on days with a lot of competing news, but it is not profitable for announcements made on days with little competing news.

Asset market experiments suggest that inexperienced investors play a role in the formation of asset price bubbles. Without first-hand experience of a downturn, these investors are more optimistic and likely to exhibit trend chasing in their portfolio decisions. Greenwood and Nagel examine this hypothesis with mutual fund manager data from the technology bubble. Using age as a proxy for managers' investment experience, they find that around the peak of the bubble, mutual funds run by younger managers are more heavily invested in technology stocks, relative to their style benchmarks, than their older colleagues. Consistent with the experimental evidence, the authors find that young managers, but not old managers, exhibit trend-chasing behavior in their technology stock investments. As a result, young managers increase their technology holdings during the run-up, and decrease them during the downturn. The economic significance of young managers' actions is amplified by large inflows into their funds prior to the peak in technology stock prices. These results are unlikely to be explained by standard career concerns models or by differences in the ability to pick technology stocks between young and old managers.

Massa and Zhang study the impact of style investing on the market for corporate control. By using data on the flows in mutual funds, they construct a measure of "neglectedness" that is not a direct transformation of stock market data, but directly relies on the identification of the sentiment-induced investor demand. They show that bidders tend to pair with targets that are relatively less neglected. The merger with a less neglected target generates a "halo effect" from the target to the bidder that induces the market to evaluate the assets of the more neglected bidder at the (inflated) market value of the less neglected target. Both bidder and target premiums are positively related to the difference in neglectedness between bidder and target. However, the target's ability to appropriate the gain is reduced by the fact that its bargaining position is weaker when the potential for asset appreciation of the bidder is higher. The effect on the value of the bidder is persistent in the medium run (1-2 years). The authors document a better medium-term performance of more neglected firms taking over less neglected ones. The bidder managers engaging in these types of "cosmetic mergers" take advantage of the temporary window of opportunity created by the higher stock price induced by the M and A deal to reduce their stake in the firm at convenient conditions.