Joseph Engelberg, Caroline Sasseville and Jared Williams of the Department of Finance at the Kellogg School of Management asked themselves exactly this question in 2005. To find the answer they studied 246 buy recommendations that Cramer made on Mad Money between July and October 2005 . You can download a .pdf copy of their excellent paper here.
Using the efficient markets hypothesis and previous research on stocks with high media attention and large one-day returns, Engelberg and his colleagues knew that individual traders tend to be net buyers of 'attention-grabbing' stocks. They also knew that 'attention-grabbing' stocks purchased by individual investors tend to generate poor returns.
Engelberg and his colleagues guessed that, on the day after each episode of Mad Money, otherwise uninformed traders would flood the market with buy orders for the stocks recommended by Cramer. They also suspected that institutional stockholders and market makers are aware that small investors buy Cramer's picks and would structure their own trades accordingly. Finally, the Kellogg researchers guessed that Cramer's predictions would have a significant and predictable impact on security prices, encouraging arbitrageurs to take the other side of the trade .
Results of the study
When Engelberg and his colleagues tested the market data for each of the 246 Mad Money buy recommendations, they discovered the following consistent outcomes for Cramer's stock picks:
- significant short-term price increases (between 1.96% and 5.19%) after he recommended them, but those gains were nearly all reversed within 12 days after the episode;
- large increases in trading volume and buy/sell imbalance over the short term (trading volume for small firms was 3 times larger than normal on the day of the recommendation, nearly 9 times normal on day 1 following the recommendation and 4.5 times normal on day 2); but
- no significant change in bid/ask spreads -- this suggests that the market makers and institutional investors did not regard Cramer's blessing as improving the value of the stocks in question.
When the Kellogg researchers discovered this consistent pattern of Cramer recommendation/price jump/price decline, they realised it created a different opportunity to ring the register. To quote page 9 of their paper:
Given the extremely high abnormal returns from selling Cramer's recommended stocks on day 1 and buying them back a few days later, we expect some traders to be aware of this strategy and to exploit the mispricing by shorting the recommended stocks.
Engelberg and his colleagues could only obtain short interest data for around 70% of the 246 buy recommendations. However, even there they found a consistent increase in the short interest ratio for Cramer's picks from the moment the market opened on the day after the Mad Money episode. The short interest spiked and did not return to its previous level until 4 days after each episode. This pattern, which we might now call the 'Kellogg Crunch' in honour of its discoverers, is clearly indicated in this chart (click to enlarge):
I can't summarise the implications of this study for small investors any better than the Kellogg researchers do on page 11 of their paper:
Taken together, our results suggest that the aggregate losers in our event study are the Mad Money viewers who decide to buy the recommended securities when the markets open the following day, and that the winners are the market makers and arbitraguers [sic] who sell the overpriced recommended stocks on day 1, as well as the traders who sell the recommended stocks on days 2 through 12.
Individual investors who watch Mad Money would be wise to wait before purchasing the small stocks Cramer recommends, as these stocks tend to fall to their original levels following the overnight price spike caused by his recommendation.
'But wait,' you say, 'I can avoid the Kellogg Crunch by running with the smart money. I'll get on the short side of Cramer's picks from now on.' Unfortunately, Engelberg and his colleagues are ahead of us on that opportunity as well. They use the same answer that the terrific Michael Mauboussin of Legg Mason gives on the paradox of efficient markets (you can download his paper here): as soon as a market inefficiency is found, traders compete it away. The Kellogg researchers conclude on page 10 of their paper that:
If... loan fees [to fund short sales] are not abnormally high, the profitability of the [short selling] strategy [identified in the study] is likely due to arbitraguer [sic] ignorance of this opportunity. If this is the case, we expect the abnormal returns to dissipate as arbitraguers learn of this opportunity and begin to compete with the specialists for the uninformed Mad Money viewers' order flow.
That pointed last sentence suggests a sleuth of hungry bears scooping fat salmon out of an Alaskan river. Who said that finance professors don't understand the stock market?