Return Reversals Research Articles

Does official media sentiment matter for the stock market? Evidence from China

We develop a novel official media sentiment index (NegGovOp) for China’ stock market using textual analysis combined with BERT. We find that NegGovOp predicts market return reversals. The return-reversal pattern is concentrated among difficult-to-arbitrage stocks, during recession period and the trading days which are not directly following weekends or holidays. We further find that official media sentiment primarily affects the trading activities of retail investors and significantly predicts market trading volume, market volatility and investor sentiment. Our findings are in line with the behavioral model that official media sentiment contributes to shaping irrational investor sentiment and resulting in temporary mispricing.

Overreaction and underreaction to new information and the directional forecast of exchange rates

Overreaction and underreaction to new information may cause, respectively, sequences and reversals in exchange rate returns. Empirical evidence is that the sign of the difference between the probabilities of a sequence and a reversal predicts the sign of the next day exchange rate return out-of-sample better than the random walk without drift model. Since the effect of overreaction of exchange rates to unexpected news dies out over longer time spans, the directional predictability becomes weaker for the weekly exchange rates. The trading strategy exploiting the directional predictability of the exchange rates generates tangible profits compared to the non-trading and buy-and-hold strategies.

Salience, psychological anchors, and stock return predictability

This study examines whether salience theory predicts the effect of a 52-week high (WH) on stocks in the Taiwanese stock market. The evidence indicates enhanced profits for WH when stocks with extremely salient payoffs are excluded. Salience-induced overvaluation mitigates investors' underreaction to good news when prices are near the WH, thus leading to non-significant positive returns for stocks with salient upsides. In contrast, salient downsides exacerbate investors' underreactions to good news when prices are close to their WHs, leading to greater positive returns. These findings do not result from short-term return reversals or investor attention. This effect is more pronounced for the stocks with higher arbitrage limits. The overestimation of the salient upsides dominates the underreaction to the WH when investors experience capital losses, high-sentiment, and upward market states.

Overnight return reversal in the Chinese stock market

ABSTRACT This article shows that the overnight return reversal is strong at a firm level in the Chinese stock market: the overnight return negatively predicts the first half-hour return of individual stocks. We explain this phenomenon from the perspective of the pre-open auction mechanism. Taking a step further, we find that the Chinese stock market shows a pattern with average negative overnight return and positive first half-hour return. Additionally, the predictability is stronger on negative overnight returns and negative informational shocks compared with positive overnight returns and positive informational shocks. Both phenomena may be led by the combined effects of the pre-open auction mechanism and T + 1 trading rule.

On the linkage of momentum and reversal – evidence from the G7 stock markets

This paper studies the linkage of momentum and reversal in the G7 stock markets. We confirm Conrad and Yavuz’s (Rev Financ 21(2):555–581, 2017) finding that momentum is not linked to subsequent return reversal in the US stock market. In the stock markets of the remaining G7 countries, our results object the decoupling of momentum and return reversal. In these stock markets, the two return anomalies are linked to each other. In particular, momentum is followed by return reversal in the stock markets of Germany, the UK, Japan, Canada, France, and Italy. These observations obtain for momentum portfolios which are made up of different risk profiles with respect to size and book-to-market ratio. Our results hold true both in raw returns and in risk-adjusted returns.

Reversal of Monday returns: It is the afternoon that matters

This study dissects the well-known Monday return reversal by separating the Monday into a morning and afternoon period. So far, the literature on the Monday return reversal is limited to the analysis of daily, primarily market returns. Using a large cross-section of U.S. intraday stock return data from 2007 to 2022, we find that only Monday afternoon but not morning returns reverse over the rest of the week. The effect is stronger for larger firms and not explained by common risk factors or earnings announcements. It is mostly prevalent for those stocks for which investor disagreement is high on Monday.

Return seasonalities in the Chinese stock market

We document strong stock return seasonalities in the Chinese stock market. Stocks performing well in a certain calendar month continue to perform well in the same calendar month in future. Furthermore, there follows a return reversal in other months, suggesting that the stock return seasonalities are more likely to be driven by temporary mispricing. Our results extend Keloharju et al. (2021) which examines the U.S. market and we show that the return seasonalities are pervasive in both developed and emerging markets. More importantly, we highlight the temporary mispricing as the common driver of return seasonalities, regardless of market conditions and development status in different markets.

A Portfolio Approach to Global Imbalances

ABSTRACTWe use a portfolio‐based framework to understand what drives the decline of the U.S. net foreign asset (NFA) position and the reversal in returns earned on the U.S. NFA (exorbitant privilege). We show that global savings gluts and monetary policies widened the U.S. NFA position, while investor demand shifts partially offset this widening. Moreover, U.S. privilege declined after 2010, in line with increasing foreign demand for U.S. equity. We also highlight a quantity dimension of the U.S. privilege: The U.S. can issue substantially more debt than other countries for a given yield increase.

Portfolio pumping and dumping among Chinese mutual fund companies

This study documents the engagement of Chinese mutual fund companies in year-end ranking games, in which they strategically buy and sell stocks substantially held by star funds and their competitors. Non-star funds contribute to approximately half of the buying and almost all selling. Fund companies actively participating in the game can attract more investment flows, but this comes at the cost of distorted relative performance among star funds and heightened return volatility across all involved funds. Furthermore, major holdings of star funds experience return reversals, increased idiosyncratic volatilities, and excessive trading around year-ends. The advent of FinTech platforms in mutual fund distribution amplifies these gaming behaviors.

Informed Trading Intensity

ABSTRACTWe train a machine learning method on a class of informed trades to develop a new measure of informed trading, informed trading intensity (ITI). ITI increases before earnings, mergers and acquisitions, and news announcements, and has implications for return reversal and asset pricing. ITI is effective because it captures nonlinearities and interactions between informed trading, volume, and volatility. This data‐driven approach can shed light on the economics of informed trading, including impatient informed trading, commonality in informed trading, and models of informed trading. Overall, learning from informed trading data can generate an effective informed trading measure.

Firm Size, Market Risk, And Return Reversal Anomalies During The COVID-19 Pandemic

This research aims to prove whether firm size and market risk based on CAPM affect return reversal anomalies as indicators of market overreaction during the COVID-19 pandemic. This explanatory research used a sample of stocks on the Indonesia Stock Exchange (IDX) that could be profitable during the pandemic period up to the effective period of phase one and two vaccination. It was found that return reversal anomalies occurred in the short term on the IDX, and contrarian strategies resulted in profits. Factors of firm size and market risk affected the reversal of returns in specific periods but did not affect other periods. When firm size and market risk had no effect, the return reversal anomaly occurred entirely due to the investors' overreaction in response to the pandemic without regard to the size and market risk factors of companies whose stocks were the investment target.

Informed trading by hedge funds

AbstractUsing daily equity transactions, we create a hedge fund informed trading measure (ITM) that separates concentrated information‐related trades from liquidity‐driven basket trades. We find that stocks with higher ITM are associated with higher future stock performance. The long–short portfolio delivers 4% annual alpha after controlling for size, value, momentum, and illiquidity factors. We attribute informed trading to hedge funds' ability to identify and correct stock underpricing. The results are robust to several ways of constructing and sorting the measure, and we do not find a return reversal in four quarters, indicating that the measure is information related.

Foreign Exchange Fixings and Returns around the Clock

ABSTRACTThe U.S. dollar appreciates in the run‐up to foreign exchange (FX) fixes and depreciates thereafter, tracing a W‐shaped return pattern around the clock. Return reversals for the top nine traded currencies over a 21‐year period are pervasive and highly statistically significant, and they imply daily swings of more than one billion U.S. dollars based on spot volumes. Using natural experiments, we document the existence of a published reference rate determines the timing of intraday return reversals. We present evidence consistent with an inventory risk explanation whereby FX dealers intermediate unconditional demand for U.S. dollars at the fixes.

Do stock prices follow random walk over day and night? -– evidence from Chinese stock market

ABSTRACT In this study, we decompose daily stock return into day and night returns and examine whether stock prices follow random walk over day and night in the Chinese stock market. Both variance ratio test and economic test reject the random walk hypothesis. Specifically, we find a significant return reversal from night to day but a significant return momentum from day to night. We also show that the unique T + 1 trading rule in China attenuates the return reversal from night to day but strengthens the return momentum from day to night.

Economic policy uncertainty and short‐term reversals

AbstractIn this article, we provide new evidence on the impact of economic policy uncertainty (EPU) on asset pricing. Specifically, we find that short‐term return reversals are stronger following high‐EPU periods, likely due to an uncertainty‐induced decrease in stock market liquidity. However, EPU does not appear to have a significant effect on accounting‐based anomalies, possibly because these anomalies are not driven by stock illiquidity. Our findings suggest that EPU affects short‐term asset prices mainly through stock liquidity. However, EPU may contain incremental information beyond stock liquidity. Moreover, the arrival of the latest fundamental information could significantly mitigate the effect of EPU on short‐term reversals.

Investigation of winner-loser portfolio anomalies and size effect anomalies in LQ45 index, Indonesia stock exchange

This study investigates the anomalies of winner-loser portfolios and anomalies of size effect on LQ45 stocks in the Indonesia Stock Exchange (IDX), period 2015-2020. The paired sample t-test (parametric) and Wilcoxon test (non-parametric) are used to test samples. Sample selection is carried out using the non-probability and purposive sampling methods. The shares of companies that met the sample criteria were 26. The primary data used cumulative abnormal returns and market capitalization as proxies for a company's stock size. The anomaly of the winner-loser effect phenomenon is observed by dividing the data into two periods: the formation period and the testing period. The periods are both short-term and long-term. The short-term period is six months, and the long-term is 12 months. The first finding shows reversals in average cumulative abnormal returns (CARs) on the winner-loser stock portfolio. In the testing period, the average CARs were turned down, and many average CARs became negative. Portfolio loser in the testing period, the average CARs reversed to positive. The second is a reversal in average CARs in winner-loser stock portfolios caused by the size effect. The performance of small winner-loser portfolios is proven to outperform big winners' portfolios. The reversal occurs in both the short-term and long-term. This finding suggests that behavioral finance can explain this market anomaly, and it is helpful for investors in coming up with strategies to get abnormal returns.

In search of distress premium in the Chinese energy sector

We explore the link between the Chinese firms' default probabilities and their stock returns with an emphasis on the energy sector. We show that energy stock portfolios sorted by probability of default (PD) demonstrate a return reversal pattern, in which the distressed energy portfolio earns a higher return than its adjacent portfolio. In contrast, PD-sorted portfolios for all Chinese A-share stocks demonstrate a strong distress anomaly puzzle. We find the energy sector distress premium, measured by buying distressed energy stocks and selling distressed stocks in other sectors, earns a significant return, and is not explained by the standard or energy factors. However, this premium is vulnerable to extreme market conditions. In a structural framework of credit premium, we exploit specific properties of the Chinese energy sector, such as the high proportion of state-owned enterprises (SOEs) and their importance to China's energy transition goals, to explain our empirical results.

The optimal time to buy and hold stock in a reversal

AbstractInvestors cannot anticipate a return reversal in the stock market. Therefore, choosing the optimal time to buy and hold a stock is vital. This paper formulates a disorder problem using the optimal stopping theory to study the optimal time to buy and hold a stock when a downward trend is about to reverse. The results show that investors should buy a stock when the conditional probability of a return reversal hits an optimal boundary for the first time. The optimal boundary is uniquely determined by the stock return, volatility, and the intensity of return reversal. Moreover, the optimal boundary decreases as the stock volatility and the intensity of return reversal increase. We use the China Securities Index 300 (CSI 300), Standard & Poor's 500 (S&P 500), Dow Jones Industrial Average (DJIA), and Russell 2000 indexes to estimate the parameters and the related optimal boundary. We find that the estimated optimal boundary can be used to time stock buying.

Asymmetric information and the distribution of trading volume

We propose the Volume Coefficient of Variation (VCV), the ratio of the standard deviation to the mean of trading volume, as a new and simple measure of information asymmetry in security markets. We use a microstructure model to demonstrate that VCV is strictly increasing in the proportion of informed trade. Empirically, we obtain VCV from daily observations of trading volume and provide extensive evidence supporting the hypothesis that VCV indicates information asymmetry, by studying return reversals, institutional ownership, and extant firm-level measures of asymmetric information in the cross-section of US stocks. Moreover, VCV increases following exogenous reductions in analyst coverage induced by brokerage closures, and steeply decreases around earnings announcements and other information disclosures.

Overnight returns and investor sentiment: Further evidence from the Taiwan stock market

This study reexamines the relationship between overnight returns and investor sentiment—a finding documented by Aboody et al. (2018, JFQA)—on the Taiwan Stock Exchange (TWSE). We aim to verify whether the overnight returns on the TWSE are reflective of investor sentiment and clarify how the trading activities of different investor types affect the patterns of overnight returns. We show that overnight returns cause short-term persistence and long-term return reversal on the TWSE, both of which are driven by investor sentiment. In addition, the percentage of retail trading enhances the patterns of overnight returns. A high individual trading volume ratio raises the tendency of short-term overnight return persistence. Our findings provide further support for the validity of overnight returns in measuring investor sentiment. When overnight returns fail to work as a valid sentiment proxy in many non-US markets, their success on the TWSE suggests that the connection with the US market, the preference of investors for chasing information, and the structure of market participants are likely to be the most important determinants of whether they are reflective of investor sentiment.