When narratives take over

I have been writing a couple of times in the past about the importance of narratives for share prices. Here, for example, I have discussed how stories are so powerful that they dominate factual information. And here, I have written about a narrative momentum strategy that creates outperformance by investing in stocks with the strongest positive narrative.

Reading through a new study by Chukwuma Dim and co-authors, I wasn’t surprised to see that they found similar things. They measured the share price beta to market narratives of all US stocks while controlling for the usual four factors of market beta, size, value and momentum and found that stocks with higher “narrative beta” saw increased noise around their share price, elevated trading volume and lower informativeness of the share price with regards to future fundamentals.

To put it simply, stocks that have strong exposure to a market narrative start to drift further and further away from fundamentals and become more volatile. Anyone who has ever seen a chart of a meme stock will not be surprised by these findings. After all, meme stocks are the ultimate narrative investments.

What is interesting about their study, however, is that they show which parts of the US market have higher exposure to market narratives and how this influences the valuation of these stocks. First, the charts below show that pharmaceutical stocks and commodity stocks have a higher exposure to the dominant market narrative. This isn’t surprising, given that much of the narrative of the last decade has been dominated by the rise of China as well as breakthrough medical treatments and of course the pandemic.

What is interesting, though, is that when it comes to narrative beta, larger stocks are far more exposed than smaller stocks. Most narrative investors will focus on the largest most prominent companies exposed to a theme. But if we combine this insight with the fact that stocks subject to narratives become unanchored from their fundamentals, it means that smaller stocks are on average much more driven by fundamentals. In other words, fundamental analysis is much more likely to be a worthwhile exercise for smaller stocks than it is for larger stocks.

Narrative beta by size (left) and sector (right)

Source: Dim et al. (2023)

And then there is one important insight that I haven’t seen investigated in previous research. Typically, we think of narratives as positive narratives that drive share prices higher. Stories like the rising Chinese consumer, the rise of AI, etc. are likely to drive valuations of affected companies to levels that can no longer be justified by fundamentals.

But in their study, the authors looked not just at positive narratives but also at negative narratives. Stories like “fossil fuel companies are going bankrupt due to the shift to renewables”, or “China is going to invade Taiwan soon”. And these negative narratives push share prices lower, well below the valuation justified by fundamentals. And in their study, the authors find that this negative effect is larger than the push from positive narratives – essentially reflecting loss aversion. What this means is that we need to pay more attention to negative narratives. Not only are these narratives able to depress share prices for a long time, but once the narrative changes (e.g. for oil companies and defence stocks after the Russian invasion of Ukraine) the outperformance can be very explosive and last much longer than many investors would expect. Knowing what the narratives are, both positive and negative is thus key to positioning a portfolio, especially in large caps.