Identifying Key Drivers of Return Reversal with Dynamical Bayesian Factor Graph

Abstract

In the stock market, return reversal occurs when investors sell overbought stocks and buy oversold stocks, reversing the stocks’ price trends. In this paper, we develop a new method to identify key drivers of return reversal by incorporating a comprehensive set of factors derived from different economic theories into one unified dynamical Bayesian factor graph. We then use the model to depict factor relationships and their dynamics, from which we make some interesting discoveries about the mechanism behind return reversals. Through extensive experiments on the US stock market, we conclude that among the various factors, the liquidity factors consistently emerge as key drivers of return reversal, which is in support of the theory of liquidity effect. Specifically, we find that stocks with high turnover rates or high Amihud illiquidity measures have a greater probability of experiencing return reversals. Apart from the consistent drivers, we find other drivers of return reversal that generally change from year to year, and they serve as important characteristics for evaluating the trends of stock returns. Besides, we also identify some seldom discussed yet enlightening inter-factor relationships, one of which shows that stocks in Finance and Insurance industry are more likely to have high Amihud illiquidity measures in comparison with those in other industries. These conclusions are robust for return reversals under different thresholds.

Return reversal effect in Shanghai A share market

“…Earlier, Kang et al (2002) investigated all Chinese A stocks and reported that there is a short-term return reversal in Chinese A stock market, whereas other empirical studies claimed that future market returns are not dependent on the past performance. However, empirical research is not limited to finding the return reversal effect in stocks, i.e., Zhao et al (2016) explored the determinants of the return reversal and found liquidity as the most important that can cause return reversal effect. Naughton et al (2008) showed that there is a momentum effect in the Chinese stock market, whereas Li et al (2010) observed no such momentum effect in the Chinese market.…”