Two essays on market behavior
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My dissertation consists of two essays which investigate how the reaction of market participants to aggregate and firm-specific information affects asset prices and firms’ corporate choices. The first essay studies the implications of investor sentiment for asset prices. It develops a novel stock-by-stock measure of investor sentiment which I call sentiment beta. Using this measure I test several hypotheses. First hypothesis postulates that sentiment affects stocks of some firms more than others due to differences in firm characteristics. Second hypothesis predicts that more sentiment sensitive stocks are more likely to be held by individual investors. Consistent with the first hypothesis, I find that more sentiment-sensitive stocks are smaller, younger, have greater short-sales constraints, idiosyncratic volatility and lower dividend yields. Given size and volatility, high sentiment beta stocks have greater analyst coverage and institutional ownership, higher likelihood of S&P500 membership, higher turnover and lower book-to-market ratios. Stocks that are more exposed to sentiment changes deliver lower future returns, which is inconsistent with the risk factor interpretation of investor sentiment. Institutional analysis reveals that institutions stayed away from sentiment-sensitive stocks in the 1980’s, but held more of these stocks since the early 1990’s. The second essay tests a catering hypothesis which predicts that firm managers concerned about the current stock price will deviate from the optimal policy in setting profitability and revenue growth targets due to the incentives to cater to the time-varying relative investor demand for firms with different composition between revenue growth and profit margins. I develop a measure which I call a revenue growth premium and document three results consistent with catering interpretation: 1) time periods when the premium is high tend to be followed by “higher-than-expected” sales and investment growth, advertising, acquisitions and R&D; 2) catering to the premium is more pronounced among firms where managers care more about the short-term stock price; 3) consistent with “bounded rationality” version of catering story, trading strategy based on longing stocks of firms with high margin surprises and shorting firms with low margin surprises when the premium is high yields 40/bp per month after adjusting for risk and post-earnings announcement drift.