Sorin M. Sorescu

Short Sale Constraints, Differences of Opinion, and Overvaluation

Miller (1977) hypothesizes that dispersion of investor opinion in the presence of short-sale constraints leads to stock price overvaluation. However, previous empirical tests of Millers hypothesis examine the valuation effects of only one of these two necessary conditions. We examine the valuation effects of the interaction between differences of opinion and shortsale constraints. We find robust evidence of significant overvaluation for stocks that are subject to both conditions simultaneously. Stocks are not systematically overvalued when either one of these two conditions is not met.

Why Do Option Introductions Depress Stock Prices? A Study of Diminishing Short-Sale Constraints

Early studies find that option introductions tend to raise the price of underlying stocks. More recent research indicates that post-1980 option introductions are associated with negative abnormal returns in underlying stocks. Other studies document increased short sale activities following option listing. This paper provides evidence that the documented abnormal returns and changes in short interest around option listings are consistent with the mitigation of short sale constraints resulting from the option introduction, and that both the abnormal returns and short interest changes around listing dates can be predicted using ex ante characteristics of the underlying stock.

The Long-run Performance Following Dividend Initiations and Resumptions: Underreaction or Product of Chance?

We examine the long-term stock performance following dividend initiations and resumptions from 1927 to 1998. We show that postannouncement abnormal returns are significantly positive for equally weighted calendar time portfolios, but become insignificant when the portfolios are value weighted. Moreover, the equally weighted results are not robust across subsamples. We also document postannouncement reductions in the risk factor loadings of underlying stocks. Cross-sectionally, these reductions are negatively related to the contemporaneous price drifts, suggesting the price drifts may be a sample-specific result of chance. Our results underscore the importance of testing for changes in risk loadings in future long-term event studies. Copyright The American Finance Association 2002.

A Reexamination of Corporate Governance and Equity Prices

We reexamine long-term abnormal returns for portfolios sorted on governance characteristics. Firms with strong shareholder rights and firms with weak shareholder rights differ from the population of firms and from each other in how they cluster across industries. Using well-specified tests under this industry clustering, we find statistically zero long-term abnormal returns for portfolios sorted on governance. Our results have important implications for interpreting studies that link governance to firm value and stock returns, demonstrate the importance of the coarseness of industry definitions in financial research, and shed light on addressing statistical problems created by industry clustering in samples. The Author 2009. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org., Oxford University Press.

Foreign Exchange Risk and the Cross-Section of Stock Returns

We examine the relation between the cross-section of US stock returns and foreign exchange rates during the period from 1973 to 2002. We find that stocks most sensitive to foreign exchange risk (in absolute value) have lower returns than others. This implies a non-linear, negative premium for foreign exchange risk. Sensitivity to foreign exchange generates a cross-sectional spread in stock returns unexplained by existing asset-pricing models. Consequently, we form a zero-investment factor related to foreign exchange-sensitivity and show that it can reduce mean pricing errors for exchange-sensitive portfolios. One possible explanation for our findings includes Johnsons [2004. Forecast dispersion and the cross-section of expected returns. Journal of Finance, 59, 1957-1978] option-theoretic model in which expected returns are decreasing in idiosyncratic cashflow volatility.

Smart Money, Dumb Money, and Capital Market Anomalies

We investigate the dual notions that “dumb money” exacerbates well-known stock return anomalies and “smart money” attenuates these anomalies. We find that aggregate flows to mutual funds (dumb money) appear to exacerbate cross-sectional mispricing, particularly for growth, accrual, and momentum anomalies. In contrast, hedge fund flows (smart money) appear to attenuate aggregate mispricing. Our results suggest that aggregate flows to mutual funds can have real adverse allocation effects in the stock market and that aggregate flows to hedge funds contribute to the correction of cross-sectional mispricing.

Customer Satisfaction and Long-Term Stock Returns.

The authors reexamine the relation between customer satisfaction (measured by the American Customer Satisfaction Index) and long-term stock returns using statistical tests that are well specified in the presence of industry clustering. Their results are consistent with those of Fornell, Morgeson, and Hult (2016), who find positive abnormal stock returns for companies with high levels of customer satisfaction. However, the authors also identify three caveats that could affect the robustness of this conclusion. First, the results critically depend on the manner in which industry is defined. Second, because Fornell, Morgeson, and Hult use a proprietary trading strategy that has not been disclosed to the general public, the authors are unable to discern what fraction of their reported performance is due to customer satisfaction as opposed to other characteristics of the trading strategy. Finally, because the authors also find positive abnormal returns for the entire American Customer Satisfaction Index sample, at least some of the performance reported by Fornell, Morgeson, and Hult might be driven by sample characteristics unrelated to customer satisfaction. This article also provides useful guidance for measuring long-term abnormal returns in the presence of industry clustering.

Capital Market Efficiency and Arbitrage Efficacy

Market efficiency requires that arbitrageurs are able to raise the capital needed to arbitrage away mispricing in the cross-section of stock returns. We identify a set of capital constraints that impede the flow of funds to arbitrage strategies. When this flow is particularly curtailed, investors are unable to fully implement arbitrage strategies, allowing some level of inefficiency to persist. In turn, this leads to higher cross-sectional return predictability and stronger performance of arbitrage strategies in the future, as mispricing is eventually corrected. Thus, the degree of market efficiency is not a static concept but varies across time as arbitrage agents face time-varying constraints to arbitrage capital.Efficiency in the capital markets requires that capital flows are sufficient to arbitrage anomalies away. We examine the relation between flows to a quantitative (quant) strategy that is based on capital market anomalies and the subsequent performance of this strategy. When these flows are high, quant funds are able to implement arbitrage strategies more effectively, which in turn leads to lower profitability of market anomalies in the future, and vice versa. Thus, the degree of cross-sectional equity market efficiency varies across time with the availability of arbitrage capital.

Short Interest, Returns, and Fundamentals

We show that short interest predicts future bad news, negative earnings surprises, and downward revisions in analyst earnings forecasts. Moreover, short interest is a better predictor of changes in firm fundamentals for stocks that are harder to short and short sellers appear to have information about these events several months before they become public. Most importantly, the well-known cross-sectional relation between short interest and future stock returns vanishes after controlling for short sellers’ information about future fundamental news. Thus, short sellers contribute in a significant manner to price discovery about firm fundamentals.

Mispricing Following Public News: Overreaction for Losers, Underreaction for Winners

We document an important relation between two well-established anomalies: momentum and short-term reversal. Only stocks with negative momentum experience short-term reversal. Using Chans (2003) news database, we show that the market appears to overreact to public news following bad past performance and underreact following strong past performance. The results are robust to using alternative methodologies. Stocks with current good news and negative momentum earn on average -9.3% annual raw returns during the subsequent month, while stocks with current good news and positive momentum earn 32.2%. The large, negative raw returns point to cognitive biases, rather than risk-based explanations, as the source of abnormal returns.