Hypothesis Development: Lead-Lag in Stock Returns

The following hypotheses were developed during class discussion on the topic of whether some groups of stock lead others in their response to news shocks. The discussion took place in the Seminar in Finance Class, MS (Management) 2013. The paper for discussion was "Do Industries Lead Stock Market" [Download]


Hypotheses derived keeping in view slow diffusion of information and behavioral biases

H₁: Firms with dispersed ownership will lead firms with concentrated ownership

Rationale: It is assumed that firms with concentrated ownership will have more information asymmetry as these firms will not share much information with the market [For literature review on this topic, you may read this paper].  In comparison, firms with dispersed ownership will have more information available. As news shocks hit the market, price discovery for firms with concentrated ownership will be difficult and hence they will react to the news with delay (similar rationale is available for non-synchronous trading hypothesis]

H₂: Firms with less managerial ownership will lead firms with more managerial ownership

Rationale: Similar rationale can be developed for managerial ownership as for concentrated ownership. If managers have intention of expropriating wealth from minority shareholders, they will try to hide information from the market. With less information, share price discovery becomes difficult and hence such firms will react with delay to new information.

H₃: Firms with higher trading volume will lead firms with lower trading volume.
Rationale: Firms with higher trading volume are more liquid and easy to price as they have more information available about them compared to firms with low trading volume. For more details, you can see paper Chordia and Swaminathan (2000) Download

H₄: Firms with high beta stocks will lead firms with low beta stocks

Rationale: Since investors give more weight to loss than to a similar gain, stock with higher betas are expected to be affected by this behavioral bias. Hence in down markets investors are expected to sell these stocks quickly whereas lower beta stocks are expected to react with delay. For up market conditions, the theoretical predictions are not much clear about the two types of stocks.

H₅: Small firms will lead large firms in down market trend.

Rationale: Though the above hypothesis seems to be in contradiction to the general finding of large stocks leading the small stocks, but based on the rational which we developed for the high beta stock it is plausible to expect that small firms will show quicker reaction to economic news in down markets (not because of information hypothesis but because of loss aversion hypothesis)

H₆: Commodity market will lead stock market

Rationale: Since economic activity is primarily originated from commodity market, information from here will reach to the stock market with delay assuming limited cognitive ability (Kahneman, 1973; Nisbett and Ross, 1980) and limited participation Merton (1987) and Hong and Stein (1999)

H₇: Firms in start of the supply chain will lead firms that are towards the end of the supply chain.

Rationale: Again the rationale is the slow diffusion of information. For details on this, you may read Menzly and Ozbas (2004)

H₈: Mature firms will lead young firms.

Rationale: Again the rationale is the slow diffusion of information. Mature firms have more information about them compared to young firms.

H₉: Stocks being followed by more analysts tend to lead stocks with no or less analysts.

Rationale: Institutional investors and analysts generate more analaysis and information about the firms in which they invest. Such firms are expected to have easier price discovery compared to other firms.

References:

Chordia, Tarun, and Bhaskaran Swaminathan. "Trading volume and cross‐autocorrelations in stock returns." The Journal of Finance 55.2 (2002): 913-935.

Hong, H., Lim, T., Stein, J., 2000. Bad news travels slowly: Size, analyst coverage, and the profitability of momentum strategies. Journal of Finance 55, 265–295.

Hong, H., Stein, J., 1999. A unified theory of underreaction, momentum trading and overreaction in asset markets. Journal of Finance 54, 2143–2184.

Hong, H., Torous, W., Valkanov, R., 2002. Do industries lead the stock market? Gradual diffusion of information and cross-asset return predictability. FEN Working Paper /http://papers.ssrn.com/sol3/papers.cfm?abstract_id=326422S.

Merton, R., 1987. A simple model of capital market equilibrium with incomplete information. Journal of Finance 42, 483–510.

Nisbett, R., Ross, L., 1980. Human Inference: Strategies and Shortcomings of Social Judgment. Prentice-Hall,New Jersey.

Kahneman, D., 1973. Attention and Effort. Prenctice-Hall, Englewood Cliffs, New Jersey.

Menzly, L., Ozbas, O., 2004. Cross-industry momentum. USC Working Paper.