News, Not Trading Volume, Builds Momentum

Recent research has found that price momentum and trading volume appear to predict subsequent stock returns in the U.S. market and that they seem to do so in a nonlinear fashion. Specifically, the effect of momentum appears more pronounced among high-volume stocks than among low-volume stocks. This effect would suggest the existence of an exploitable deviation from market efficiency. We argue that this phenomenon is a result of the underreaction of investors to earnings news—an effect that is most pronounced for high-growth companies. We show that, after earnings-related news and a stock's growth rate have been controlled for, the interaction between momentum and volume largely disappears. Both empirical research and stock market lore suggest that momentum and trading volume in the U.S. equity market predict subsequent returns and that they do so in a nonlinear fashion. Specifically, the effect of momentum appears to be more pronounced among high-volume stocks than among low-volume stocks (this is the “momentum–volume effect”). This effect would suggest the existence of a predictable deviation from market efficiency that is exploitable through technical trading rules. One of the possible explanations for this phenomenon is the “momentum life cycle. ” This explanation suggests that stocks cycle sequentially through intervals of glamour and neglect, exhibiting high trading volume during periods of glamour and low trading volume during times of neglect. For example, high-volume stocks with low momentum would be considered to be in an early stage of a move from glamour to neglect and would be expected to exhibit lower subsequent returns relative to low-volume, low-momentum stocks, which would be near the trough of an interval of neglect. We examined volume and return data for a sample of 1,500 companies between 1981 and 1998 and also found a relationship between momentum and volume. We propose a different explanation from the momentum life cycle, however—an explanation based on investor reaction to news about company fundamentals. We argue that news about a company's prospects often creates trading volume and a change in stock price. That is, momentum occurs because news precipitates a change in expectations, which generates trading and a change in stock price. Furthermore, news creates greater volume and greater momentum for high-growth stocks, which are more sensitive to information about future earnings than are low-growth stocks. We argue that some of the reaction to news is delayed while overconfident investors slowly adjust their beliefs. Just as the initial reaction is greater for growth stocks, the delayed reaction is also greater for growth stocks. This nonlinear reaction to earnings news about stocks with different growth rates creates the nonlinearities in the momentum–volume interaction. In short, we believe that the momentum life cycle is explainable as a delayed reaction to news about company fundamentals that is strongest for high-growth stocks and that there is nothing special about volume per se. To reach this conclusion, we show that (1) trading volume is positively correlated with both the amount of fundamental news and a company's growth rate and (2) a delayed reaction to earnings-related news is greater for rapidly growing stocks. Our proxy for news is the net number of upward changes in earnings forecasts made by security analysts following a stock. Once we controlled for news and growth, we found that the apparent interaction between momentum and trading volume disappeared. Furthermore, the impact of news on subsequent performance appears to be more robust than the impact of momentum. Very bad news always resulted in significantly negative subsequent performance, whereas very low momentum did not. Additionally, regardless of momentum, stocks with very good news had subsequent returns that were consistent with the direction of the news (typically, significantly positive or zero) but such was not the case for momentum, where subsequent returns were occasionally of the opposite sign. These observations suggest that a substantial portion of the momentum effect can be explained as investors' delayed reaction to news. Our measure of news does not, however, explain all of the momentum effect. For example, the average excess return in the subsequent quarter for stocks with no news increased monotonically from the lowest- to the highest-momentum quintile. We believe that this apparently independent momentum effect is likely to be underreaction to news not captured in our forecast-revision measure. We conclude that, although momentum may be correlated with subsequent performance, momentum by itself does not contain information about future performance. Viewed in a framework that is consistent with valuation theory and the arrival of information, the momentum–volume effect, we find, is a manifestation of a richer phenomenon driven by investors' lagged responses to news. Although this finding does not preclude successful technical trading strategies, a more fruitful approach would focus directly on the apparent lagged response to news.