Disagreement and Stock Market

Journal of Economic Perspectives—Volume 21, Number 2—Spring 2007—Pages 109 –128

Disagreement and the Stock Market

Harrison Hong and Jeremy C. Stein

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ver the last 20 years, the field of behavioral finance has grown from a startup operation into a mature enterprise, with well-developed bodies of both theory and empirical evidence. On the empirical side, the benchmark null hypothesis is that one should not be able to forecast a stock’s return with anything other than measures of its riskiness, such as its beta. This hypothesis embodies the familiar idea that any other form of predictability would represent a profitable trading rule and hence a free lunch to investors. Yet in a striking rejection of this null, a large catalog of variables with no apparent connection to risk has been shown to forecast stock returns, both in the time series and the cross-section. Many of these results have been replicated in a variety of samples and have stood up sufficiently well that they are generally considered to be established facts. One prominent set of patterns from the cross-section has to do with mediumterm momentum and post-earnings drift in returns. These describe the tendency for stocks that have had unusually high past returns or good earnings news to continue to deliver relatively strong returns over the subsequent six to twelve months (and vice-versa for stocks with low past returns or bad earnings news). Early work in this area includes Jegadeesh and Titman (1993) on momentum and Bernard and Thomas (1989, 1990) on post-earnings drift. Another well-established pattern is longer-run fundamental reversion—the tendency for “glamour” stocks with high ratios of market value to earnings, cashflows, or book value to deliver weak returns over the subsequent several years (and vice-versa for “value” stocks with low ratios of market value to fundamentals). Standard references for this

y Harrison Hong is Professor of Economics, Princeton University, Princeton, New Jersey....