Star analysts and price synchronicity in the United States and China

Investor reaction to research and news

Brokers and money managers have long differentiated markets where individual investors trade more actively from those where institutional investors contribute more to daily trading activity in shares. Traders who deal with ETFs and algorithms or trades which follow a specific program have somewhat complicated how we measure the contribution of retail investors versus the institutional ones to trade.

However, what has not changed is the profound difference in reaction to events between individual and institutional investors, which is well established.  There are two markets, in particular, where one can observe the behavioral difference between institutions and individuals. The more sophisticated US institutions and the retail investors in the Chinese markets, who probably make up the two extremes of global investors’ universe with all other investor categories falling in between. 

Star analysts and stock price synchronicity

Posing a similar question on investor reaction to analyst coverage and news, recent academic research —notably Zhou, 2016 and 2017— have examined investor behavior towards stock related news and brokerage research reports. In the 2017 FMA article, Zhou have published the results of their research looking into the relationships among (1) star analyst coverage, (2) investor overreaction to events, and (3) stock price synchronicity in the US and China. The price synchronicity is measured as the R-square in a two-index model where the indices are (1) the value-weighted market portfolio and (2) a value weighted industry portfolio.

The article reports evidence for presence of strong negative correlation between star analyst coverage and price synchronicity in China but not in the US. Star analyst coverage indeed appears to induce investor overreaction leading to notable trend reversals across Chinese equity markets —specifically the A-shares traded either on the Shanghai or Shenzhen exchanges— but not so much in the US markets. The article also provides evidence that the overreaction is more pronounced in stocks held and traded primarily by retail investors in China. In stark contrast, star analyst coverage and price synchronicity are positively correlated in the United States. There is no statistically significant association between star analyst coverage and investor overreaction itself.

Conclusion

There is no surprise in any of their test results. Indeed, any market trader or stock analyst would probably attest the notion that individual investors tend to overreact not only to analyst reports but also to other news, be it company, sector or macro. Using the findings of the article and recent academic research we have read on stock price synchronicity with investor overreaction and our own observations across emerging markets over the years, we summarize below what we believe to be the major differences between the two contrasting sets of market reaction to what star analysts publish or communicate or any related news.

Institutional versus retail investors

The difference between the market reaction in the U.S. and that in China to research reports published by star analysts is largely due to the size and influence of institutional money managers in giving direction to shares. Trading across the US markets is largely influenced by institutional funds including mutual, pension or hedge funds while there is significant retail investor presence in the Chinese equity markets where research coverage by star analysts does tend to have greater footprint on share price behavior, which may result in market overreaction or mispricing.

Small versus large-cap stocks

Equity market capitalization is also an important differentiating factor in understanding market reaction or overreaction to news and various analyst reports. Small-cap stocks do react more aggressively to (1) directional research reports by star analysts, (2) earnings revisions or material updates, and (3) changes in management guidance than the larger-cap stocks do.

Daily trade volumes

The daily activity in shares is a third and yet another important factor in shaping daily price actions. The stocks with low trade volumes tend to react more quickly and too often excessively to star analyst coverage than those stocks with higher daily volumes do. There is significant overlap between the shares with thin trade volumes and small equity market capitalization. 

The impact of thin trading in small cap shares on market reaction is something stock traders would easily attest. In contrast, large-cap stocks command deeper and more liquid markets and offer more sophisticated or balanced reactions to news.

References

Zhou, Mingshan; Jing Lin, and Yunbi An (2017) - Star Analysts, Overreaction, and Synchronicity: Evidence from China and the United States, Financial Management, Volume 46, Issue 3. pp. 797-832

Zhou, Mingshan; J. Lin, and N. Xu (2016) - Star Analyst Coverage and Stock Price Synchronicity: Empirical Evidence based on Market Overreaction, Journal of Management Sciences in China, Volume 19,pp. 49-73.