Who Underreacts to Cash-Flow News? Evidence from Trading between Individuals and Institutions

Abstract

A large body of literature suggests that firm-level stock prices 'underreact' to news about future cash flows, i.e., shocks to a firm's expected cash flows are positively correlated with shocks to expected returns on its stock. 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. Although institutions are trading in the 'right' direction, institutions as a group outperform individuals by only 1.44 percent per annum before transaction and other costs, because they are extremely conservative in deviating from the value-weight market index.