Hong, Lim, and Stein (2000) present supportive evidence for the view
of Hong and Stein (1999) that momentum is due simply to slow diffusion of
private information through the economy. They argue that the diffusion of
information will be particularly slow among small firms and among firms
with low analyst coverage, and that the momentum effect should therefore
be more prominent there, a prediction they confirm in the data. They also
find that among firms with low analyst coverage, momentum is almost en-
tirely driven by prior losers continuing to lose. They argue that this, too, is
consistent with a diffusion story. If a firm not covered by analysts is sitting
on good news, it will do its best to convey the news to as many people as
possible, and as quickly as possible; bad news, however, will be swept
under the carpet, making its diffusion much slower.
5.2. Belief-based Models with Institutional FrictionsSome authors have argued that models which combine mild assumptions
about investor irrationality with institutional frictions may offer a fruitful
way of thinking about some of the anomalous cross-sectional evidence.
The institutional friction that has attracted the most attention is short-
sale constraints. As mentioned in section 2.2, these can be thought of as
anything which makes investors less willing to establish a short position
than a long one. They include the direct cost of shorting, namely the lend-
ing fee; the risk that the loan is recalled by the lender at an inopportune
moment; as well as legal restrictions: a large fraction of mutual funds are
not allowed to short stocks.
Several papers argue that when investors differ in their beliefs, the exis-
tence of short-sale constraints can generate deviations from fundamental
value and in particular, explain why stocks with high price/earnings ratios
earn lower average returns in the cross-section. The simplest way of moti-
vating the assumption of heterogeneous beliefs is overconfidence, which is
why that assumption is often thought of as capturing a mild form of irra-
tionality. In the absence of overconfidence, investors’ beliefs converge rap-
idly as they hear each other’s opinions and hence deduce each other’s private
information.
There are at least two mechanisms through which differences of opinion
and short-sale constraints can generate price/earnings ratios that are too
high, and thereby explain why price/earnings ratios predict returns in the
cross-section.
Miller (1977) notes that when investors hold different views about a
stock, those with bullish opinions will, of course, take long positions. Bear-
ish investors, on the other hand, want to short the stock, but being unable
to do so, they sit out of the market. Stock prices therefore reflect only the
opinions of the most optimistic investors which, in turn, means that they
are too high and that they will be followed by lower returns.
44 BARBERIS AND THALER