"Highly Predictable Volume Leads to Highly Predictable Returns"

In the paper described below, the "attention-grabbing" hypothesis plays a key role:

A specific story involving irrational or cognitively constrained investors is the "attention-grabbing" hypothesis... According to this hypothesis, individual investors both have limited attention, and rarely sell short. When a stock which they currently do not own grabs their attention, these individual investors are more likely to buy the stock (compared to a stock which does not grab their attention). Institutional investors are less attention constrained....

Do these investors cause an "announcement premium" by rushing to buy stocks that are in the news?:

Stocks Rise Around Earnings Announcements, by Matt Nesvisky. NBER Digest: It has long been observed that when firms announce their quarterly earnings, as they are required to do, considerable price volatility and increases in trading volume are evident. In addition, in the days around earnings announcements, stock prices usually rise. In The Earnings Announcement Premium and Trading Volume..., Owen Lamont and Andrea Frazzini explore why these phenomena occur. ...

In general, of course, stocks tend to rise on high volume and to decline on low volume, but Lamont and Frazzini say that whether this happens because of the interpretation of the announcements or because of irrational or random traders is uncertain. What may well be in play is that certain earnings announcements simply "grab attention," with the result that individual investors are motivated to buy in.

The researchers focus on this "attention-grabbing" hypothesis, because stocks that make news - whether good, bad, or neutral -- have both high volume and high net buying by individuals. Lamont and Frazzini note that arbitrageurs might be expected to eliminate this anomaly, but this would require substantially increased trading activity, which is costly. In addition, the highly idiosyncratic volatility around earnings announcements could deter traders who, for whatever reason, cannot sufficiently diversify. If idiosyncratic risk is somehow preventing arbitrage activity, then in this limited sense the premium may be viewed as a reward for bearing risk. Lamont and Frazzini see evidence that ... arbitrageurs are trading on the anomaly, but simply have not yet eliminated it. Whatever the case, because earnings announcements occur frequently and regularly and generate substantial volume, they provide a good opportunity for testing ... whether predictable volume generates predictable returns. ...

The researchers demonstrate that the strategy of buying every stock expected to announce within the coming month and shorting every stock not expected to announce yields a return of over 60 basis points per month. The announcement premium is thus substantial, particularly among large cap securities, lasts about four weeks, and is evident in samples going back to 1927. At the same time, stocks with the largest predicted volume increases in announcement months ... tend to have higher subsequent premiums. These stocks also tend to have the highest imputed buying around announcement dates by small investors.

Lamont and Frazzini add that the evidence increasingly shows that individual investors seem to make uninformed trading decisions. In line with the attention-grabbing hypothesis, ... small-investor buys ... soar on announcement day. ... One explanation for these phenomena is that some securities attract small attention-constrained investors around earnings announcement dates. Since such investors rarely sell short, the predictable rise in volume boosts prices around announcement dates, thus generating a seasonal component in the stock's expected return.

These results fit with the broader research on the connection between trading activity and prices. Elements such as liquidity, information flow, heterogeneous beliefs, and short sale constraints arguably are all important in understanding this connection. Lamont and Frazzini's findings impose an additional requirement on any theory attempting to connect volume and prices. Any hypothesis, the researchers assert, must now explain why highly predictable volume leads to highly predictable returns. Their ... explanation is uninformed or irrational demand by individual investors, coupled with imperfect arbitrage by informed traders.