Abstract
The efficient market hypothesis is one of the most popular subjects in the empirical finance literature. Previous studies of the stock markets, which are mostly based on fixed-time price variations, have inconclusive findings: evidence of short-term predictability varies according to different samples and methodologies. We propose a novel approach and use drawdowns and drawups as triggers, to investigate the existence of short-term abnormal returns in the stock markets. As these measures are not computed within a fixed time horizon, they are flexible enough to capture subordinate, time-dependent processes that could drive market under- or overreaction. Most estimates in our results support the efficient market hypothesis. The underreaction hypothesis receives stronger support than does overreaction, with higher prevalence of return continuations than reversals. Evidence for the uncertain information hypothesis is present in some markets, mainly after lower-magnitude events.
Highlights
In 2008, when Queen Elizabeth II asked a group of professors at the London School of Economics why nobody had noticed the financial crisis coming,1 Her Majesty was probably unaware she was addressing one of the most important and controversial topics in Finance: the predictability of the financial markets
We propose using drawdowns and drawups as triggers, in order to investigate the existence of short-term abnormal returns in stock markets, using ten different stock price indexes from developed and emerging markets
The defined threshold of 2σ helps limit our analysis to large price variations, and is consistent with previous studies related to stock market indexes
Summary
In 2008, when Queen Elizabeth II asked a group of professors at the London School of Economics why nobody had noticed the financial crisis coming, Her Majesty was probably unaware she was addressing one of the most important and controversial topics in Finance: the predictability of the financial markets. Amini et al (2013) offer a broad and detailed review on the short-term predictability of stock markets after the observation of large price variations, comparing different markets, time periods and methodologies used in the empirical research. They suggest that future research could benefit from using different ways to define large returns, such as looking at those conditional on other factors. Our results show a great variety of estimates across the different stock market indexes in the sample This variety is evidence that price behavior after large drawdowns and drawups varies according to country-specific market features.
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