Cognitive Dissonance, Sentiment, and Momentum

TL;DR: The authors empirically show that momentum profits arise only under optimism, and that losers (winners) become underpriced under optimism (pessimism) by short-selling constraints may impede arbitraging of losers and thus strengthen momentum during optimistic periods.

Abstract: We consider whether sentiment affects the profitability of momentum strategies. We hypothesize that news that contradicts investors’ sentiment causes cognitive dissonance, slowing the diffusion of such news. Thus, losers (winners) become underpriced under optimism (pessimism). Short-selling constraints may impede arbitraging of losers and thus strengthen momentum during optimistic periods. Supporting this notion, we empirically show that momentum profits arise only under optimism. An analysis of net order flows from small and large trades indicates that small investors are slow to sell losers during optimistic periods. Momentum-based hedge portfolios formed during optimistic periods experience long-run reversals.

Figures

Table 1 Descriptive Statistics

Table 13. Post-event small and large investor order imbalance for losers with low SUE

Table 7 Risk-adjusted Momentum Profits Conditional on Investor Sentiment

Table 2 Momentum Profits Conditional on Investor Sentiment

Table 14 Long-run Profits of Momentum Portfolios Conditional on Investor Sentiment

Table 6 Momentum Profits Conditional on Investor Sentiment and Firm Size

Table 10 Momentum Profits Conditional on Different Specifications of Investor Sentiment

Table 9 Momentum Profits Conditional on an Alternative Investor Sentiment Index

Table 11. Earnings announcements and momentum

Table 5 Momentum Profits Conditional on Investor Sentiment and Analyst Coverage

Figure 1 Investor sentiment (CB) from 1966-2008

Full text

ORE Open Research Exeter
TITLE
Cognitive dissonance, sentiment and momentum
AUTHORS
Antoniou, Constantinos; Doukas, John A.; Subrahmanyam, Avanidhar
JOURNAL
Journal of Financial and Quantitative Analysis
DEPOSITED IN ORE
05 February 2013
This version available at
http://hdl.handle.net/10036/4272
COPYRIGHT AND REUSE
Open Research Exeter makes this work available in accordance with publisher policies.
A NOTE ON VERSIONS
The version presented here may differ from the published version. If citing, you are advised to consult the published version for pagination, volume/issue and date of
publication

Electronic copy available at: http://ssrn.com/abstract=1479197
Sentiment and Momentum
Constantinos Antoniou
John A. Doukas
Avanidhar Subrahmanyam
This version: May 20, 2011
Abstract
This paper sheds empirical light on whether sentiment affects the profitability of price
momentum strategies. We hypothesize that news that contradicts investors’ sentiment causes
cognitive dissonance, which slows the diffusion of signals that oppose the direction of sentiment.
This phenomenon tends to cause underpricing of losers under optimism and underpricing of
winners under pessimism. While the latter phenomenon can be corrected by arbitrage buying,
short-selling constraints impede arbitraging of losers under optimism, causing momentum to be
stronger in optimistic periods. Our empirical analysis supports this argument by showing that
momentum profits arise only under optimism, and are driven principally by strong momentum in
losing stocks. This result survives a host of robustness checks including controls for market
returns, firm size and analyst following. An analysis of net order flows from small and large
trades indicates that small (but not large) investors are slow to sell losers during optimistic
periods. Momentum-based hedge portfolios formed during optimistic periods experience long-
run reversals.
Antoniou is from XFI Centre for Finance and Investment, University of Exeter. Doukas is from
Old Dominion University and Judge Business School, University of Cambridge. Subrahmanyam
is from the Anderson School, University of California, Los Angeles. Address correspondence to
A. Subrahmanyam, The Anderson School at UCLA, Los Angeles, CA 90095-1481, email:
subra@anderson.ucla.edu, phone (310) 825-5355. We thank an anonymous referee, Hank
Bessembinder (the editor), Sridhar Arcot, Werner DeBondt, Andras Fulop, Stuart Gabriel,
Soeren Hvidkjaer, Murali Jagannathan, Dennis Lasser, Ken Lehn, Laurence Lescourret, Haim
Levy, Yee Cheng Loon, Hanno Lustig, Marios Panayides, Richard Roll, Kristian Rydqvist, Steve
Salterio, Eduardo Schwartz, Carmen Stefanescu, Geoff Tate, Shawn Thomas, Premal Vora,
Neng Wang, and seminar participants at ESSEC, University of Pittsburgh, UCLA, Indira Gandhi
Institute of Development Research, Indian Institute of Management (Kolkata), SUNY-
Binghamton, and the 2010 Asian Finance Conference in Hong Kong, as well as the Second
Annual Research Symposium on Current Issues in Accounting and Finance at Brock University,
for valuable comments, and the Conference Board for kindly providing us with the sentiment
data. We also are grateful to Jeffrey Wurgler and Malcolm Baker for making their sentiment
index publicly available.

Electronic copy available at: http://ssrn.com/abstract=1479197
Sentiment and Momentum
Abstract
This paper sheds empirical light on whether sentiment affects the profitability of price
momentum strategies. We hypothesize that news that contradicts investors’ sentiment causes
cognitive dissonance, which slows the diffusion of signals that oppose the direction of sentiment.
This phenomenon tends to cause underpricing of losers under optimism and underpricing of
winners under pessimism. While the latter phenomenon can be corrected by arbitrage buying,
short-selling constraints impede arbitraging of losers under optimism, causing momentum to be
stronger in optimistic periods. Our empirical analysis supports this argument by showing that
momentum profits arise only under optimism, and are driven principally by strong momentum in
losing stocks. This result survives a host of robustness checks including controls for market
returns, firm size and analyst following. An analysis of net order flows from small and large
trades indicates that small (but not large) investors are slow to sell losers during optimistic
periods. Momentum-based hedge portfolios formed during optimistic periods experience long-
run reversals.

4
Introduction
Does sentiment affect financial asset prices? This issue is enduring and has taken on renewed
significance in the context of dramatic rises and falls in the stock market during this decade. We
address this question by examining whether variations in profitability from a key pattern in stock
prices, namely, stock price momentum, can be explained by variations in sentiment. Notably,
our sentiment proxy is measured outside of the financial markets, as we use the Consumer
Confidence Index® published by the Conference Board (CB) (orthogonalized with respect to a
set macroeconomic variables).
The phenomenon of price momentum has been documented in several studies [e.g.,
Jegadeesh and Titman (1993, 2001); Chan, Jegadeesh, and Lakonishok (1996)] and is well
known to survive consideration of standard risk adjustments [Fama and French (1996)]. This
return pattern is found to be robust across different markets [Rouwenhorst (1999); Doukas and
McKnight (2002)] and different asset classes [Asness, Moskowitz, and Pedersen (2008)]. The
highly debated explanations for price momentum range from time-varying expected returns [e.g.,
Johnson (2002)] to rationales based on market frictions and investor psychology [Hong and Stein
(1999); Daniel, Hirshleifer, and Subrahmanyam (1998)].
1
We shed light on the latter class of
arguments by examining the relationship between momentum-induced profits and sentiment.
Sentiment, broadly defined, refers to whether an individual, for whatever extraneous
reason, feels excessively optimistic or pessimistic about a situation. A large body of the
psychology literature finds that peoples’ current sentiment affects their judgment of future
events. For example, Johnson and Tversky (1983) show that people that read sad newspaper
articles subsequently view various causes of death, such as disease etc., as more likely than
people who read pleasant newspaper articles. In general, the evidence indicates that people with
positive sentiment make optimistic judgments and choices, whereas people with negative
1
Empirically, Hong, Lim, and Stein (2000) show that, controlling for firm size, momentum profits are decreasing in
analyst coverage, thus supporting the notion that momentum is caused by slow information diffusion as suggested
by the model of Hong and Stein (1999). Chordia and Shivakumar (2002) find that momentum profits are largely
predictable from a set of macroeconomic variables, proposing a rational explanation for momentum. Cooper,
Gutierrez, and Hameed (2004) find that momentum returns are entirely captured by lagged market returns, and
suggest a behavioral explanation of momentum. For further discussions on the causes of momentum, see Conrad
and Kaul (1998), Moskowitz and Grinblatt (1999), Grundy and Martin (2001), and Grinblatt and Han (2005).

5
sentiment make pessimistic ones [Bower (1981, 1991); Arkes, Herren, and Isen (1988); Wright
and Bower (1992); among others].
We augment the Hong and Stein (1999) arguments to establish a link between sentiment
and momentum. Their framework indicates that news diffuses slowly through the actions of
different sets of “newswatchers” that sequentially react to news, and this creates momentum. A
class of “momentum traders” trades reflexively in response to past price movements. Some
momentum traders mistake price movements due to previous momentum trades as fundamental
news movements. Their reactive trades set off an overreaction that eventually is corrected as
momentum positions are reversed. We hypothesize that “newswatchers” will underreact more
strongly when they receive information that contradicts their sentiment due to cognitive
dissonance [Festinger (1957)]. This implies that bad (good) news among loser (winner) stocks
will diffuse slowly when sentiment is optimistic (pessimistic). In turn, this will lead to
momentum, albeit driven by the loser portfolio in optimistic sentiment periods and the winner
portfolio in pessimistic sentiment periods. Although this argument alone predicts symmetric
momentum across sentiment periods, as a practical matter momentum may be more pronounced
when sentiment is optimistic because arbitraging cognitive dissonance in these states requires the
costly short selling of loser stocks.
To ensure that our sentiment measure is free of macroeconomic influences, like Baker
and Wurgler (2006, 2007), we conduct our investigation using the residual from the regression of
the CB Index on a set of macroeconomic variables. The variables include growth in industrial
production, real growth in durable, non-durable, and services consumption, growth in
employment and a National Bureau of Economic Research (NBER) recession indicator.
2
Furthermore, in our robustness checks, we also consider the alternative index for investor
sentiment constructed by Baker and Wurgler (2006, 2007).
To summarize our results, we find that when sentiment is optimistic the six-month
momentum strategy yields significant profits, equal to an average monthly return of 2.00%.
However, when investor sentiment is pessimistic, momentum profits decrease dramatically to an
2
These indicators are used in Baker and Wurgler (2006, 2007) to extract “excessive” investor sentiment from the
sentiment index developed in Baker and Wurgler (2006).

Frequently asked questions

Q1. What are the future works mentioned in the paper "Sentiment and momentum" ?

Exploration of this issue would seem to be an interesting area for future research. 

Q2. What are the contributions mentioned in the paper "Sentiment and momentum" ?

This paper sheds empirical light on whether sentiment affects the profitability of price momentum strategies. This result survives a host of robustness checks including controls for market returns, firm size and analyst following. The authors thank an anonymous referee, Hank Bessembinder ( the editor ), Sridhar Arcot, Werner DeBondt, Andras Fulop, Stuart Gabriel, Soeren Hvidkjaer, Murali Jagannathan, Dennis Lasser, Ken Lehn, Laurence Lescourret, Haim Levy, Yee Cheng Loon, Hanno Lustig, Marios Panayides, Richard Roll, Kristian Rydqvist, Steve Salterio, Eduardo Schwartz, Carmen Stefanescu, Geoff Tate, Shawn Thomas, Premal Vora, Neng Wang, and seminar participants at ESSEC, University of Pittsburgh, UCLA, Indira Gandhi Institute of Development Research, Indian Institute of Management ( Kolkata ), SUNYBinghamton, and the 2010 Asian Finance Conference in Hong Kong, as well as the Second Annual Research Symposium on Current Issues in Accounting and Finance at Brock University, for valuable comments, and the Conference Board for kindly providing us with the sentiment data. 

Q3. What is the effect of the momentum trading style on the performance of the winners and losers?

14profitability of the momentum trading style is susceptible to significant time variation, since the returns of the winner and the loser portfolios do not preserve their spread across optimistic and pessimistic sentiment states. 

Q4. How long does it take to remove all stocks that are priced less than one dollar?

In order to avoid microstructure biases, the authors allow one month between the end of the formation period and the beginning of the holding period, and delete all stocks that are priced less than one dollar at the beginning of the holding period. 

Q5. What is the average momentum profit in pessimistic periods?

When momentum profits are partitioned to three sentiment categories, and J,K=6, the optimistic and mild sentiment categories yield average momentum profits of 1.40% and 1.67%, respectively. 

Q6. Why do the authors believe that market returns are related to investor sentiment?

Market returns can, of course, be related to investor sentiment [Otoo (1999)], because, forexample, as market returns increase, investors may potentially become more optimistic. 

Q7. How do the authors determine the average momentum profits in a month?

The results show that, once the authors exclude losers with negative earnings surprises, average momentum profits in optimistic periods drop remarkably, from 1.92% to 0.91% per month. 

Q8. What is the augmented version of the Hong and Stein theory?

Their augmented version of the Hong and Stein (1999) theory indicates that this is caused by cognitive dissonance toward negative news during optimistic periods. 

Q9. What is the significance of momentum profits?

Their analysis indicates that momentum profits are significant only when investors are optimistic (i.e., when the sentiment measure is high). 

Q10. How do the authors isolate the role of analyst following vis-à-vis size?

As in Hong, Lim, and Stein (2000), in order to isolate the role of analyst following vis-à-vis size, the authors perform the monthly cross-sectional regression log(1+analysts)=a + b*log(size) + e. 

Q11. What is the evidence that the investor sentiment has a dramatic impact on the profits of momentum strategies?

While the evidence so far suggests that conditioning on investor sentiment has a dramatic impact on the profits of momentum strategies, the authors have not addressed the possibility that the higher (lower) returns of the winner (loser) portfolio during periods of optimism load more (less) strongly on economic risk factors.