CFA Institute Journal Review 2018 Volume 48 Issue 7
Volume Shocks and Stock Returns: An Alternative Test (Digest Summary)
Pacific-Basin Finance Journal
Stocks experiencing a positive volume shock tend to outperform. A strategy that buys stocks experiencing high-volume shocks and sells stocks experiencing low-volume shocks generates positive risk-adjusted returns for up to 12 months after initiation; the return premium diminishes as time goes on. There is no evidence that volume shock is a priced risk factor.
How Is This Research Useful to Practitioners?
The contemporaneous and dynamic relationships between trading volume and stock returns have interested financial economists and analysts for decades because they provide insights into the microstructure of financial markets. The price–volume relationship is considered an important one because it relates to the role of information in price formation—in particular, how information is disseminated in the market. Because stock prices change when new information arrives, there is an obvious relationship between prices and trading volumes.
The necessary preconditions for price persistence in previously unknown stocks are awareness, familiarity, and purchase. The authors explore whether the effect of trading volume is merely fleeting or whether it is useful in predicting the direction of future price movements. If successful, investors could exploit a high-volume return premium.
How Did the Authors Conduct This Research?
A volume shock is a spike in the number of shares traded. In this study, the authors define a volume shock as an increase or decrease in monthly trading volume relative to a stock’s 12-month average. They test the high-volume effect at both the portfolio and individual stock levels in the Australian equity market over the period 1992 to 2013. The Australian market provides an interesting contrast to previous studies that focused on institutional investors because more than 70% of stocks in the sample were priced below US$1, making them unsuitable for institutional investors.
Measuring changes in monthly volume at the individual company level, the authors categorize stocks with unusually large increases or decreases in volume relative to both their average volume and the typical variation around those averages as experiencing a shock. The theory is that investor attention leads to temporary positive price pressure.
The authors create equal- and value-weighted portfolios of stocks experiencing volume shocks ranked in the top 10% (i.e., high portfolio) as well as in the bottom 10% (i.e., low portfolio). The high portfolio experiences one-month returns of 2.87%, whereas the low portfolio experiences one-month returns of –0.05%. Performance declines as the volume shocks decrease in magnitude and is more pronounced in stocks with low prices, small market capitalizations, low levels of institutional ownership, and low turnover—all of which serve as proxy for companies with low visibility that were previously less well-known to investors.
Shares of large companies experience less benefit from volume shocks because they were better known to begin with compared with small companies. The spike in volume is said to draw attention to the stock, and this increase in visibility results in more trading activity. The magnitude of the resulting return premium declines as the holding period is extended. In fact, it dissipates rather quickly; 12 months after the shock, the monthly returns between the high and low portfolios are essentially equal.
The role of volume shocks in the generation of stock returns depends on what drives volume shocks and serial correlation in daily stock returns, but it is unclear why volume shocks necessarily reflect “smart money” or “informational” trading. Technical analysts strongly believe that volume is required to make prices move.
The observed outperformance in this study is of such a short-term nature that it seems like a sideshow until longer-term macro factors and risk premiums play out. The fact that most of the effect is found in the smallest of names is reminiscent of Bill Sharpe’s criticism of Fama and French’s work: that most of the small-cap premium comes from an exceptionally small percentage of the market.
About the Author(s)
Rich Wiggins, CFA, is at Saudi Aramco.