Extreme Return Reversal in the Stock Market

Abstract

According to the efficient markets hypothesis, market returns are unpredictable and random around long-term market norms. In a perfectly efficient market, historical returns offer no useful insight into the formation of future return expectations. Behavioral finance theory suggests otherwise. Even if nobody can predict when the market will take a severe drop (such as down 20%), the overreaction hypothesis suggests that forward-looking returns will be above average after severe market drops. Market evidence presented here shows that severe downturns in the overall market are consistently followed by superior returns during the 12 months following. When investors overreact by giving extreme weight to recent negative returns, they run the risk of missing subsequent above-average rates of return. Going forward, the overreaction hypothesis predicts a reversal of the sharp losses following the collapse of the Internet stock bubble and the terrorist attacks on New York City and Washington.