Gradual Information Diffusion and Contrarian Strategies
43 Pages Posted: 10 Oct 2002
Date Written: March 2006
In this paper, I test the gradual information diffusion model of Hong and Stein (1999) using return reversals. This model predicts that both momentum and reversal returns are due to the gradual dissemination of firm specific information across the investing public. Employing firm size and analyst coverage as proxies, I show that the profitability of contrarian strategies declines sharply with the rate of information diffusion. This finding is consistent with the prediction of the model that return reversals should be more pronounced among stocks for which firm specific information diffuses slowly. In addition, I show that the effect of analyst coverage is most important for glamour stocks. I suggest that a bigger fraction of the information on glamour stocks is ambiguous, and that analyst coverage is important to differentiate real glamour stocks from mere overpriced ones.
Keywords: Underreaction, overreaction, contrarian, information diffusion
JEL Classification: G10, G14
Suggested Citation: Suggested Citation