Stock Price Reactions to News and the Momentum Effect in the Korean Stock Market

• Author: Dongweon Lee,Jaeho Cho
• Date: 01 August 2014
• Published date: 01 August 2014
• DOI: http://doi.org/10.1111/ajfs.12058

Stock Price Reactions to News and the

Momentum Effect in the Korean Stock

Market*

Dongweon Lee**

Business School, Seoul National University

Jaeho Cho

Business School, Seoul National University

Received 3 June 2013; Accepted 12 February 2014

Abstract

By analyzing how stock prices respond to public news, this paper examines the momentum

effect in the Korean stock market. It is true that, as a whole, the momentum strategy gen-

erates no profits in Korea. However, among the stocks in a momentum portfolio, loser

stocks with news headlines make significantly positive profits caused by negative return

drift. These positive profits are cancelled out by negative returns, due mostly to reversals

exhibited by winner stocks with and without public news. These reversals stand in contrast

to the case of the United States market, where winner stocks show weak drift (Chan,

2003). Reversals of news winners and the drift of news losers in Korea imply that stock

prices react asymmetrically to public news, which is overlooked in existing studies on

momentum. Further analyses indicate that this asymmetric reaction can be attributed to

transaction costs rather than to the incentive of managers to disclose bad news slowly. In

addition to the asymmetric reaction of prices to news, we suggest that market mispercep-

tions concerning firms’ future prospects may also be a reason for the post-news return pat-

terns in Korea.

Keywords Asymmetric reaction; Korean stock market; Market misperceptions; Momentum;

Public news

JEL Classification: G12, G14

*Acknowledgements: We are grateful to the associate editor, three anonymous reviewers, and

the seminar participants at the Business School of Seoul National University for their com-

ments and suggestions. We also thank the Institute of Management Research of Seoul

National University for the research support.

**Corresponding author: Dongweon Lee, 413, SK building (58), Business School, Seoul

National University, 1 Gwanak-ro, Gwanak-gu, Seoul 151-916, Korea. Tel: +82-2-880-6854,

Fax: +82-2-876-8411, email: dongweonlee78@gmail.com.

Asia-Pacific Journal of Financial Studies (2014) 43, 556–588 doi:10.1111/ajfs.12058

556 ©2014 Korean Securities Association

1. Introduction

Momentum has been a prevalent stock market anomaly since Jegadeesh and Titman

(1993) found that, in the United States market, longing stocks with high returns

over the past months and shorting stocks with low returns over the same period

generate profits for the following year. Many subsequent studies report that the

profitability of this momentum strategy is also pervasive throughout the world (see,

Rouwenhorst, 1998; Griffin et al., 2003). However, Korea is an exception: Chui

et al. (2003, 2010) find that Korea is among the few countries for which positive

momentum profits do not exist. Similar results are reported by a number of Korean

studies.

1

While there is plenty of debate over the sources of momentum profits, some

studies attempt to explain why these profits are absent in certain countries, most of

which are in Asia. Chui et al. (2010) focus on cultural differences. Using an individ-

ualism index related to behavioral factors such as overconfidence and self-attribu-

tion bias, they find that countries with weaker levels of individualism have lower

momentum profits, and vice versa. In contrast, Du et al. (2009) test the state-depen-

dence of momentum profits in the Taiwan stock market, where, as a whole, no

momentum profits exist either. They find that the momentum strategy there gener-

ates negative returns in down markets, whereas it produces substantial profits in up

markets. They further show that down markets occur more frequently in Taiwan

than in the United States. Thus, they maintain that the magnitude of momentum

profits depends on the state of the market and not on differences among investors’

behaviors.

Meanwhile, major theories on momentum argue that momentum profits arise

because investors react slowly to new information. In Barberis et al. (1998), inves-

tors are subject to conservatism and representativeness heuristics. Therefore, they

may slowly update their forecasts on a firm’s future performance in the face of new

information. Also, they connect future earnings too strongly with past performance.

In Daniel et al. (1998), investors suffer from overconfidence and self-attribution

bias. Therefore, they overestimate the precision of their own private informati on

and underweight newly released public signals. Hong and Stein (1999) categorize

investors into two groups: “news watchers” and “momentum traders.” They argue

that because the latter group ignores new information and reacts only to price

changes, new information diffuses gradually. Thus, they explain momentum without

depending on behavioral biases. In sum, all three models agree that investors’ und-

erreactions to new public information make the momentum strategy profitable,

although they rely on different assumptions.

From this point of view, Chan’s (2003) results shed light on how investors react

to public news. He documents that stocks with public news exhibit momentum in

the United States stock market, whereas stocks without news do not. Specifically,

1

See section 2 and Kim and Byun (2011) for details.

Stock Price Reactions to News in Korea

©2014 Korean Securities Association 557

loser stocks with news headlines show strong negative return drift. Winner stocks

with news headlines also displayed drift, although the degrees are smaller. In con-

trast, loser stocks without news exhibit reversals. These reversals and drift appear

mainly among smaller and more illiquid stocks. If stocks with substantial price

changes and news headlines convey public information, these results imply that

investors respond slowly to this information. Thus, Chan (2003) demonstrates that

his findings are generally consistent with the arguments of all three of the afore-

mentioned models.

This paper adds to this line of research by investigating how stock prices

respond to public news in the Korean stock market and how the effectiveness of

the momentum strategy is in turn affected. Using comprehensive Korean news data,

we examine post-return patterns after substantial price movements with and with-

out accompanying news headlines. First, we compute momentum profits by con-

structing zero-investment portfolios that buy winner stocks and short-sell loser

stocks. We find that stocks with news headlines generate significantly positive prof-

its approximately 1 year after the news while the entire set of stocks does not. This

result supports the argument that momentum is caused by slow responses of inves-

tors to new information on stocks.

Further, we examine size- and B/M-adjusted returns in each leg of long–short

portfolios. We find that the momentum profits of news stocks are induced mainly

by the return drift of loser stocks with news. Winner stocks with news show signifi-

cant reversals after the news and thus offset the profits from loser stocks. In addi-

tion, winner stocks without news exhibit overreactions, thus lowering overall profits

further. The return reversals of winner stocks are in contrast to the case of the Uni-

ted States markets, where winners exhibit weak drift. This constitutes the difference

between the two markets –the momentum strategy does not work in Korea,

whereas it does in the United States. Table 1 provides a summary of these results.

Reversals of news winners and the drift of news losers are likely to result from

the asymmetric reaction of stock prices to public news, which is overlooked in the

existing literature on momentum. However, there are two possible explanations for

this phenomenon. First, according to Hong et al. (2000), bad news tr avels slowly,

Table 1 A summary of post-news stock return patterns in the Korean and the United States

market

Korea United States

Winners

With news Reversal Drift

Without news Reversal Drift

Losers

With news Drift Drift

Without news Reversal Reversal

D. Lee and J. Cho

558 ©2014 Korean Securities Association