Distinguishing Between Rationales for Short-Horizon Predictability of Stock Returns

Abstract

In this paper, we shed light on short-horizon return reversals. We show theoretically that a risk-based rationale for reversals implies a relation between returns and past order flow, whereas a reversion in beliefs of biased agents does not do so. The empirical results indicate that returns are more strongly related to own-return lags than to lagged order imbalances. Thus, the evidence suggests that monthly reversals are not completely captured by inventory effects and may be driven, in part, by belief reversion. We do find that returns are cross-sectionally related to lagged imbalance innovations at horizons longer than a month.

A Closer Look at the Short-Term Return Reversal

“…To ensure that our results are not unduly affected by the bid-ask bounce, we follow Subrahmanyam (2005), among others, and examine calendar-month returns computed using mid-quotes. The results, presented in panel C of Table 4, show that the residual-based reversal strategy evaluated using mid-quote-based calendar-month returns delivers an even higher profit.…”

“…Shiller (1984), Black (1986), Stiglitz (1989), Summers and Summers (1989), and Subrahmanyam (2005), among others, have suggested that short-term reversal profits are evidence that market prices may reflect investor overreaction to information, or fads, or simply cognitive errors. We label this the sentimentbased explanation.…”

Momentum is really short-term momentum

“…Among them, Jegadeesh and Titman (1995a) and Subrahmanyam (2005) suggest that short-term reversal profits are evidence that market prices may reflect investor overreaction to information, while models in 1 We assume that the exposures to the three Fama-French factors are timeinvariant in this paper. Wu (2002) shows that by incorporating conditioning information of some market-wide financial variables, the three factors are able to capture both short-term momentum and long-term reversal.…”

Industries and Stock Return Reversals

“…If the reversals are related to non-informational (liquidity) factors, the arrival of public news about the firm should increase the noise in past returns as a proxy for non-informational shocks, leading to a weakening of the reversal returns (Nagel (2012)). An alternative explanation of short-term reversals is that they represent overreaction of stock prices to firm specific news (Lehmann (1990), Cooper (1999) and Subrahmanyam (2005)), which implies greater reversals following periods of earnings news. After controlling for the drift in stock prices associated with the announcement of company's quarterly earnings (Bernard and Thomas (1989)), we find that intra-industry loser (winner) stocks revert less after an earnings announcement, particularly after negative (positive) earnings news.…”