Overreaction and Market efficiency

Overreaction and Market efficiency

What are the research questions?

Recent empirical research in finance has discovered the most important challenges to market efficiency, and helped to build the foundations of Behavioral Finance. However, the effect of investors behavior on stock prices is still under study i.e. whether the reaction is appropriate or is overreaction to the unexpected information.

But what is appropriate reaction and How it is quantified?

One school of statistics Baye’s rule which have a norm of probability revision with the arrival of new information prescribes the appropriate or correct reaction.

However, D. Kahneman and A. Tversky in their study "Intuitive Prediction: Biases and Corrective Procedures” concluded that Baye’s rule is not an appropriate method how individuals respond to new data. In revising their beliefs, individuals tend to overweight recent information and underweight prior data.  Study found that people seem to make predictions according to a simple matching rule: "The predicted value is selected so that the distribution of outcomes matches its standing in the distribution of impressions".

Further W. F. M. De Bondt’s. "Does the Stock Market Overreact to New Information?" with considerable evidence concluded that the actual expectations of professional security analysts and economic forecasters display the same overreaction bias.

Supporting Evidence:

J. B. Williams in his study “Theory of Investment Value” found that prices have been based too much on current earning power and too little on long-term dividend paying power.

. K. J. Arrow has concluded that the excessive reaction to current information which seems to characterize all the securities and futures markets. Two specific examples of the research to which Arrow was referring are the excess volatility of security prices and the so-called price earnings ratio anomaly (Stocks with extremely low P/E ratios (i.e., lowest decile) earn larger risk-adjusted returns than high P/E stocks).

Wait. Financial Economists have an opposite stance to P/E anomaly?

Most financial economists regard the anomaly as a statistical artifact. Explanations are usually based on alleged misspecification of the capital asset pricing model (CAP M).

R. Ball ‘s "Anomalies in Relationships Between Securities' Yields and Yield-Surrogates” emphasizes the effects of omitted risk factors. The P/E ratio is presumed to be a proxy for some omitted factor which, if included in the "correct" equilibrium valuation model, would eliminate the anomaly. But, hypothesis is untested unless omitted factors are identified.

M. R. Reinganum. "Misspecification of Capital Asset Pricing: Empirical Anomalies Based on Earnings' Yields and Market Values." has claimed that the small firm effect subsumes the P/E effect and that both are related to the same set of missing (and again unknown) factors. However, S. Basu. "Investment Performance of Common Stocks in Relation tn Their Price-Earnings Ratios: A Test of the Efficient Market Hypothesis." found a significant P/E effect after controlling for firm size.

An alternative behavioral explanation for the anomaly based on investor overreaction is what Basu called the "price-ratio" hypothesis. Companies with very low P/E's are thought to be temporarily "undervalued" because investors become excessively pessimistic after a series of bad earnings reports or other bad news. Once future earnings turn out to be better than the unreasonably gloomy forecasts, the price adjusts.

If stock prices systematically overshoot then their reversal should be predictable from past return data alone, with no use of any accounting data such as earnings. This imply a violation of weak-form market efficiency.

Overreaction Hypothesis Test

 “Does Stock Market Overreact”

Werner F.M. De Bondt and Richard Thaler tested overreaction hypothesis. Two portfolios "winner" (W) and "loser" portfolios (L) are formed conditional upon past excess returns, rather than some firm-generated informational variable such as earnings. ^[1]

If the investors overreact neither of the returns portfolio will outperform the market.

Starting in December 1932 cumulative excess returns CUI for the prior 36 months is computed. The step is repeated 16 times for all nonoverlapping three-year periods. The CU is ranked are ranked low too high to form portfolio.

The following is a summary of their findings:

-         Result is in violation of Bayes' rule, most people "overreact" to unexpected and dramatic news events.

-         The result of the test is consistent with overreaction hypothesis.

-         Overreaction effect is asymmetric (much larger for losers than for winners)

-         Most of the excess returns are realized in January.

There are some other notable aspects, portfolio of prior losers substantially outperformed the prior winners.

The large positive excess returns earned by the loser portfolio every January. If in early January selling pressure disappears and prices "rebound" to equilibrium levels, why does the loser portfolio outperform the market and "rebound" every January.

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[1] Data: Monthly return data for New York Stock Exchange (NYSE) common stocks, as compiled by the Center for Research in Security Prices (CRSP) (Period: January 1926 and December 1982)