Informed Trading, Earnings Surprises, and Stock Returns

Abstract

Entries and exits are often triggered by substantive private information, and we propose PC_NII, the percentage change in the number of a stock’s institutional investors, as a measure of informed trading. Over the 1982 to 2010 period, the top PC_NII decile outperforms the bottom PC_NII decile by 10% and 14% per annum for equal- and value-weighted portfolios, respectively. PC_NII subsumes the information content of standard institutional trading or herding measures in the forecast of stock returns, and the predictive power of PC_NII reflects its information content of future earnings surprises. The relationship between PC_NII and short-run future stock returns has attenuated noticeably for the equal-weighted portfolio since the Securities and Exchange Commission introduced Regulation Fair Disclosure in October 2000; however, we do not observe such a change for the value-weighted portfolio.

JEL Classification: G12, G20