Who Underreacts to Cash-Flow News? Evidence from Trading between Individuals and Institutions
45 Pages Posted: 25 May 2001
A large body of literature suggests that firm-level stock prices "underreact" to news about future cash flows. We estimate a vector autoregession to examine the joint behavior of returns, cash-flow news, and trading between individuals and institutions. Our main finding is that institutions buy shares from individuals in response to good cash-flow news, thus exploiting the underreaction phenomenon. Institutions are not simply following price momentum strategies: When price goes up in the absence of positive cash-flow news, institutions sell shares to individuals. The response of institutional ownership to cash-flow news is weaker for small stocks. Since small stocks also exhibit the strongest underreaction patterns, this finding is consistent with institutions facing exogenous constraints in trading small stocks.
Keywords: Underreaction, Overreaction, Cash-flow news, Expected returns, Individuals, Institutions, Trading
JEL Classification: G12, G14, M41
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