ACADEMICS, traders and money managers are forever trying to figure out what makes stocks rise and fall.

Some influences are clear, like the price gain after a company reports surprisingly strong earnings. But as experts drill deeper, other behaviors are mystifying.

What explains the price patterns of stocks that share special features like return on assets, rates of total accruals and rates of net stock issues?

For years, two theories have tried to explain such anomalies in stock returns. The first says that investors may have reached a keen understanding of hard-to-detect risks associated with these special features. If so, unusually large price gains would reflect a risk premium.

The second theory suggests that these unexpected gains and losses are a result of mispricing - that is, when investors pay too much or too little for a stock relative to the stock's underlying fundamentals.

Now, new research by Wharton finance professor Robert F. Stambaugh and two colleagues has unearthed strong evidence for the mispricing theory, discovering that market-wide investor sentiment is a key influence. "Our study looks at investor sentiment as a potentially important source of mispricing," Stambaugh says. "In other words, when investor sentiment is high, do things get overpriced? And if they do, can we see evidence of that influence?"

Anomalies

Stambaugh and his colleagues - Yu Yuan, a visiting professor at Wharton, and Jianfeng Yu of the Carlson School of Management at the University of Minnesota - identified 11 features associated with stock price changes that defy easy explanation.

One of these features (which the researchers refer to as "anomalies" in their paper) is a company's growth in assets like plant equipment, fleets of vehicles, property and inventories - anything on the asset side of the balance sheet. Others include firms in financial distress, firms that issue new shares of stock, those with high accruals and those showing share-price momentum, as well as firms with gross profitability premium, and those distinguished by their return on assets and the ratio of investments to assets. For instance, "companies that have grown their assets the most do, on average, produce lower subsequent returns on their stock, which presents a bit of a puzzle," Stambaugh says.

If the risk-based theory were true, companies with high rates of asset growth must be seen by investors as less risky than companies with low rates of asset growth.

But there is no obvious reason for investors to regard such firms as less risky, Stambaugh says. "What gets this thing called an anomaly to begin with is that previous attempts by others to try to attribute these price changes to risks have not been successful."

If risk is not the explanation, "the obvious alternative is that somehow the market misprices these things." One potential cause? Investor sentiment - a mood - carries these stock prices up or down to a degree that cannot be explained by fundamentals like earnings and revenues.

To examine this possibility, Stambaugh and his colleagues combined two concepts that researchers have investigated separately. "The first concept is that investor sentiment contains a market-wide component with the potential to influence prices on many securities in the same direction at the same time," they write in their paper, "The Short of It: Investor Sentiment and Anomalies," which was published in the May issue of the Journal of Financial Economics. This is what happens during bubbles, when investor exuberance pushes prices above the levels that can be justified by standard measures of value.

Short selling

The second concept, according to the researchers, "is that impediments to short selling play a significant role in limiting the ability of rational traders to exploit overpricing." "It is not as easy to short as it is to go out and buy a stock," Stambaugh notes.

Combined, the two concepts suggest that when market sentiment is very positive, there are many overpriced stocks instead of just a few - as would be the case if markets operated efficiently.

In an efficient market, investors quickly spot stocks that are overpriced or underpriced, selling the former and buying the latter.

The reduced demand for overpriced stocks drags prices down until those stocks are no longer overpriced, while higher demand for underpriced stocks pushes prices up, eliminating the underpricing.

But because it is harder to sell stocks short to bet on a price drop than it is to buy stocks to bet on a gain, stocks could be more likely to be overpriced when enthusiasm is high than to be underpriced when it is low.

If this proved to be true, stocks' different price behavior following periods of high and low sentiment would show that investor sentiment is indeed a factor in pricing. Further, if the disparity could be detected in the stocks with anomalous pricing behavior, it would help explain why the anomalies happen.

Short selling is a trading technique for betting on a price drop. In effect, the investor borrows a block of shares from a securities firm and then sells them at the current price. If the price falls, the borrowed shares can be replaced with ones purchased for less, and the investor profits by having sold high and bought low.

Although the concept is simple, there're many impediments to betting on a price decline.

Because the transaction involves a loan from a securities firm, the investor must set up a special account, which can require approvals and charges one does not encounter when buying a stock.

The upshot: It is easier for a wave of positive sentiment to drive the price up than for negative sentiment to drive it down, making overpricing more likely than underpricing.

"Investors with the most optimistic views about a stock, relative to the views of other investors, exert the greatest effect on the stock's price, because their views are not counterbalanced by the valuations of the relatively less optimistic investors," Stambaugh and his colleagues write. The Internet-stock bubble of the late 1990s was an example. The optimists drove prices too high, because it was difficult for pessimists to counterbalance the enthusiasm.

Adapted from China Knowledge@Wharton, http//www.knowledgeatwharton.com.cn. To read the original version, please visit: http://bit.ly/LtJKAC