“Contrarian Investors and Stock Returns” by Yuzhao ZHANG
We investigate the relation between aggregate stock returns and the capital flows to the stock market from contrarian investors, defined as those whose capital flows are in the opposite direction from those of the representative agent. It is shown that flows from contrarian investors reveal information about the representative agent's risk aversion in a model in which the representative agent displays time varying risk aversion and investors have heterogeneous preferences. The key implication is that the flows of contrarian investors predict market returns. We construct a contrarian flow measure using the capital flows from all major market participants and find, consistent with our theoretical prediction, that the contrarian flow is a good forecaster of returns at quarterly horizons. The predictability is robust to other known return predictors. Moreover, the predictability is stronger for growth stocks than for value stocks which, together with the notion that growth stocks bear more discount rate risk, supports our hypothesis that the contrarian flow measures the market risk premium.