Can We Predict the Direction of the Tomorrow Price Change?

Abstract

We investigate a shift in market norm from an efficient state, where prices are unpredictable, to the state where overconfidence spreads by contagion. Overconfidence means investors will buy more stocks that have enjoyed recent gains. It suggests that price shocks in a recent past may explain the signs of the price changes in the next period. To verify our conjecture, we run the Dickey – Fuller test for Dow Jones indexes and fail to reject the hypothesis of a unit root. But the residuals of the ARIMA process produced by this failure show some evidence that overconfidence, or more generally, overreaction, does play some role in determining price changes. Based on that evidence, we form a simple model to predict the direction of price changes in the next period. The forecasts fit the data reasonably well.