Are Korean Industry-Sorted Portfolios Mean Reverting?

Abstract

(ProQuest: ... denotes formulae omitted.)I. INTRODUCTIONThis paper tests the weak-form efficient market hypothesis for Korean stock markets. The weak-form efficient market hypothesis implies that stock returns are not predictable using past returns. A well-known alternative to this hypothesis is the mean reversion hypothesis stating that stock prices tend to return a trend path in the long run. In empirical finance, many studies test the efficient market hypothesis, using various empirical methods and data sets, and report mixed evidence on the predictability of stock in particular for mean reversion in long horizons.For example, Fama and French (1988, p. 538) report that 25-45 percent of the variation of 3-to 5-year stock returns is predictable from past returns, using monthly data of US stock prices in the 1926-85 period. Porteba and Summers (1988) find similar results of mean reversion over long horizons.1 In contrast, Richardson and Stock (1989) show that the univariate variance ratio tests employed in previous studies are not consistent when the return horizon is large relative to sample size and generate negative biases. Once these biases are corrected, they find little evidence of mean reversion even in long horizons in contrast to Fama and French (1988) and Porteba and Summers (1988).2 As summarized in Campbell et al. (1997), one difficulty in using long horizon returns (multi-year returns) for testing efficient market hypothesis and for detecting mean reversion is the very small sample size: standard econometric tests generally lack of power to reject the null hypothesis that stock prices follow a random walk process against the alternative of mean reversion.In this paper, we use panels of KOSPI industry group stock portfolio indexes for the period of 1988-2016 and of KOSDAQ industry group stock portfolio indexes for the period of 2001-2016. The use of panels mitigates the small sample size problems because they contain additional information in cross-industry variations. The idea of using a panel data set in testing the predictability of stock prices is from Balvers et al. (2000) who examine mean reversion using a panel of stock price indexes for 18 countries with well-developed capital markets (16 OECD countries plus Hong Kong and Singapore) in the period of 1969-1996 and find strong evidence of mean reversion. Gropp (2004) also follow Balvers et al. (2000) and employ a panel of 16 US industry-sorted portfolios for the period of 1926-1998 and find evidence of mean reversion in industry stock price indexes. Following Fama and French (1988) and Gropp (2004), we use industry group stock portfolio indexes, rather than using size-sorted portfolios (classified by market capitalization) which have been widely used in previous studies. The reason for this selection is related to one key difference between industry-sorted portfolios and size-sorted portfolios: stocks with abnormal high or low returns tend to move across portfolios from one year to next in the latter. Therefore, if abnormal performance of stocks is caused by temporary shocks, subsequent price reversals would be missed and thus detection of mean reversion would be underestimated. On the other hand, stocks in general do not move across portfolios in the former.To test the weak-form efficient market hypothesis using the panel data sets, we use panel variance ratio tests recently developed by Moon and Velasco (2014). Variance ratio tests have been widely used to detect mean reversion in long horizon returns in various asset markets such as stock and currency markets.3 However, the use of the tests has been limited only for univariate time series. Further, as Richardson and Stock (1989) and Deo and Richardson (2003) pointed out, the univariate variance ratio tests face statistical difficulties in particular for testing long horizon returns. Recently, Moon and Velasco (2014) develop the panel variance ratio tests which resolve those statistical difficulties. …