How Salient Information Impacts Stock Momentum and Reversals

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Stock momentum refers to the tendency of assets that have been performing well to continue outperforming others over a certain period. This phenomenon is rooted in the belief that existing trends are likely to persist. A reversal occurs when the direction of a price trend shifts, transitioning from an upward to a downward movement, or vice versa.

Reference [1] examines stock momentum and reversals, employing a metric called “deviation salience (DS).”  This metric is determined by taking the absolute difference between the monthly excess stock return and the average excess return of peer stocks during the same period. It is then normalized by the sum of the absolute excess returns of the stock in question and its peers.  The authors pointed out,

Earlier studies suggest that investors tend to underreact to ordinary news but overreact to salient news. Using a firm-level salience measure based on the relative distance of the focal firm’s return in the past month to its peers’ return in the past month, we find that there is indeed short-term momentum among low-salience firms, whereas there is a strong short-term reversal among high-salience firms. These results are robust after controlling for a battery of compounding effects. Our study highlights the importance of salience in asset pricing. In future research, it would be interesting to study the role of salience in other markets such as the bond market or the foreign exchange market. It would also be fruitful to build salience into otherwise standard models to account for asset pricing phenomena.

In other words, stocks with high DS demonstrate short-term reversals, providing a return spread of -1.30% per month. Conversely, low-DS stocks exhibit return continuation with a return spread of 1.41% per month.

These results are consistent with the observation that investors tend to overreact to salient information but underreact to non-salient information.

Let us know what you think in the comments below or in the discussion forum.

References

[1] Chen, Yili and Wang, Huaixin and Yu, Jianfeng, Salience and Short-term Momentum and Reversals (2023). https://ssrn.com/abstract=4649393

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