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.
Highlights
In the stock market, return reversal occurs when investors sell overbought stocks and buy oversold stocks, reversing the stocks’ price trends
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
As a matter of fact, the liquidity factors consistently appear as the key drivers, which supports the theory of liquidity effect. 2) all the similarity measures, except that for year 2011, are below 1, reflecting that apart from the consistent drivers, other drivers of return reversal generally change from year to year
Summary
Return reversal occurs when investors sell overbought stocks and buy oversold stocks, reversing the stocks’ price trends. Apart from the extensive research on market price analysis [1,2,3,4,5,6,7], return reversal has attracted lots of attention. Bondt and Thaler [8, 9] initially documented long-term return reversal in the US stock market, indicating that stocks performed well in the past three to five years tend to have low future returns. Lehmann [10] and Jegadeesh [11] first recorded that short-term return reversal, weekly and monthly reversals, exist among US stocks. Chang et al [16] provided empirical evidence on return reversal in the Japanese stock market
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