Question

In the Hong-Stein (1999) model of under-reaction and over-reaction, which type of firm would you expect to have more momentum and then consequently a bigger reversal when news occurs?

1) A small firm that sells its product to lots of retail customers (consumers)
2) a similarly sized small firm that sells its product to a few specialized firms.

Answer 1

According to Hong Stein model, there are 2 types of traders-

Informed traders – they move slowly but have naïve expectations as they do not have information about the rest of the traders or the market conditions

Momentum traders – they base their expectation on past price movements and move quickly

The under or over reaction in the prices is primarily due to the momentum traders. The momentums are short lived and are normalized due to the informed traders over a period of time. This model predicts that both the momentum and the reversal are due to the gradual dissemination of information in the investing public. The momentum effect is lower when the firm specific information is disseminated faster due to multiple factors including- widely available data, wider coverage, larger size and reach of the firm etc. If the information is limited and slow to reach the investing public, the momentum effect will be more profound. Now lets to come to the example in hand. Both the firms are small so the analyst coverage for them is expected to be low. Any small changes in the input parameters such as sales will have larger impact on the price movements. Moreover since the firm size is small the impact will be larger. For a firm which has a wider retail consumer base, the information in the market is more easily available as compared to a firm which has a smaller and niche client base. Such firm will have very limited information available for the investing public. Additionally, any changes to a single client will have even greater impact on the supplying firm. Hence, in second case, the impact of news will be bigger as compared to the first firm.