We can only explain a small portion of the variation in stock returns. We can tie returns with several key factors as displayed by the now classic three and four factor models of Fama-French. While these represent useful models for describing stock returns, their focus is on quantifiable measures of factors such as risk, size, value, and momentum. There is no factor that represents unscheduled news or sentiment in the market. However, there is a growing body of work that emphasizes narrative information such as Google search and sentiment. Popular stories, measured by search, can influence economic behavior that then impacts stock returns. Attention to news that is novel can help explain stock returns.
I have highlighted the work of Nicholas Mangee who has not been given enough attention. This is not directly related to the exploding LLM work. Rather it is a simpler and thus more powerful as a foundational approach to explaining stock returns. News, especially unscheduled information, creates narrative to explain which then impact return. Simple stories attract attention which then translates into price moves. If there are more stories with the same narrative, there will be trends in price as these narratives take hold and embedded in the price. From narratives, there is a reason for price trends.
Mangee is coming out with a new book on the novelty-narrative-hypothesis that can help advance our thinking about narratives and stock returns. I have seen a copy, and I am impressed. I will be writing more about this in the futures. It should have strong application for macro and commodity managers were there is less clear information to help with valuation.
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