Return predictability and overreaction of investors in the stock market have an impact on the efficient market hypothesis. This research paper has examined the evidence of this statement in the existing literature by economists and behavioural psychologists. The role of the efficient market hypothesis in the stock market has also been explored, along with the influences of investors to either overreact or underreact as a result of new information on the stock market. The issue of how plausible the prediction of a stock market is has also been addressed. In addition, the research paper has attempted to explore the way return predictability of a stock and the overreaction of investors in such a market influence the hypothesis of an efficient market.
This essay has been divided into two parts. The first section is more of a statement regarding the economic and finance issues under examination, in this case Stock Market Overreaction and Return Predictability and the Implications for the Efficient Markets Hypothesis. The objective of the research study is to assess how return predictability and stock market overreaction impacts on the efficient markets hypothesis. In light of this, the intention of this research paper is to help answer the question, do stock market overreaction and return predictability impact on the efficient market hypothesis? The study has made use of research questions to help shed light on the issue at hand. The second part of the essay involves the review of literature by various scholars who have dwelt on the topic at hand at a deeper level. To start with, the essay explores the theory of an efficient market from a historical perceptive. In addition, various controversies that surround the theory are addressed. The issue of stock market overreaction has been explored as well. Further, the essay has examined explanations as to why investors would either opt to overact following new information regarding a stock, or to underreact on the same. The implications of either an underreaction or an overreaction by investors on the theory of an efficient market have been explored. The essay further assesses the predictability of stock returns with supporting evidence from scholars who have documented evidence of stock predictability. Moreover, the essay has endeavored to explore the implications of stock predictability to individual investors, and more so with respect to the hypothesis of an efficient market.
Modern finance hinge on the hypothesis of an efficient market. In an efficient market, the expectation is that price will be a depiction the fully available information, and this prevents certain traders from making abnormal profits (1). Furthermore, with an efficient market, assessing the return predictability becomes far much easier. However, the stock market is regarded as irrational and the traders involved are also more inclined to behave accordingly (2). In as far as the stock market is concerned there are advocates of return predictability who are of the opinion that this market is governed by the rationality of the investors. On the other hand, the evolutionary principle, as it relates to the stock market holds that when market conditions are changed constantly, this acts as the driving force of certain elements of the market mainly the predictability of its returns. In light of this, this study endeavors to examine the hypothesis of an efficient market as it relates to the stock market (3). In addition, the issue of the stock market overreaction shall be addressed, along with its return predictability. Finally, the study endeavors to examine how return predictability and stock market overreaction impacts on the efficient markets hypothesis. Therefore, the intention of this research paper is to help answer the question, do stock market overreaction and return predictability impact on the efficient markets hypothesis?
The study shall endeavour to answer a number of research questions:
- Is the stock market governed by the efficient market hypothesis?
- What influence investors to overreact or underreact to new information on the stock market?
- Can return predictability of a stock be always predicted?
- How does return predictability of a stock and market overreaction impact on the hypothesis of an efficient market?
These research questions are important because by answering them, they help to shed light on the operations of the stock market. Accordingly, investors are better placed to make more informed decisions on the stocks to buy or sell without compromising their investments too much.
Efficient markets hypothesis (EMH)
According to the hypothesis on an efficient market, the prices of a market are a depiction of the full information available to such a market (7). This idea was independently developed during the 1960s by Eugene Fama and Paul Samuelson and has found widespread application in the empirical studies and theoretical models involving the process of price discovery and the financial securities prices. The hypothesis has over time generated significant controversy, with behavioral economists and psychologists amongst the most enduring critics. According to these critics, the EMH hinges upon rationality (3). Although stating of the EMH appears disarmingly simple, nonetheless, the hypothesis remains quite resilient to either refutation or empirical proof. Although numerous studies have been published on this hypothesis and years dedicated to its research, however, economists are yet to collectively agree if markets- and more so the financial markets- can actually be regarded as efficient.
Since EMH deals with the question of why security markets experience changes in price and the manner in which such changes occur, it has profound implications for the finance managers and investors as well. A majority of the investors including investment managers are convinced that they are in a position to select securities with the potential to outperform others in the market (1). Consequently, they have resorted to the use of various valuation and forecasting techniques to help them arrive at their investment decisions. However, according to the EMH, the potential gains of securities are by far above the cost incurred in researching on and transacting such securities. This implies that all of these various techniques are quite effective. As a result, it becomes quite hard for a single individual to outperform the market in a predictable way. The EMH also offers a suggestion on how challenging it is for an investor to profit by merely predicting the movements of prices, not to mention that this is also an unlikely event.
When new information arrives at the stock market, this is bound to result in price changes. An ‘efficient’ market is one in which the adjustment of prices occurs quickly (10), devoid of any bias, following the release of new information. Consequently, current securities prices are a reflection of all the information that is available to such a market, within a given time. As a result, it becomes no longer plausible to dwell on how low or high prices are. Adjustments in security prices occur even before an investor has had enough time to trade on the stocks that they hold, thereby profiting from the transaction after new information has reached the market. Intense competition amongst investors is believed to be the fundamental reason why an efficient market may exist as they endeavor to profit following the release of new information in the market.
One of the most common challenges facing the EMH involves an inconsistency in which the returns of an asset are reliable, inexplicable and widely known (3). Given that this pattern is not only reliable but also regular, this is an indication of a certain level of predictability. In addition, owing to the regularity of the returns of a stock, the implication for a majority of the investors is that they may opt to exploit it. ‘Size effect’ still remains an enduring anomaly. This is a term used in reference to the obvious additional expected returns in excess usually incurred by stocks owned by firms with a small capitalization.
Although EMH has in recent decades received a lot of attention from economists and behavioral psychologists, and while it is relatively simple in theory, nonetheless, the hypothesis remains controversial. In any case, the EMH attempts to address investors’ ability to constantly identify mis-priced securities. Needless to say, this is an implication that has been questioned by a majority of the active portfolio and financial managers. Debatably, in those liquid markets where participants are many (for example, the stock market), adjustment in prices ought to be quick and in a manner that is without bias following new information. While investors are more likely to factor in ‘surprises’ in stock earnings while computing future market prices, however, there are instances whereby investors may be more inclined to underreact to new information regarding future stocks earnings already accounted for in current earnings. This phenomenon resembles the ‘post-earnings announcement drift’ (6) puzzle that was for the first time captured by Brown and Ball. According to this puzzle, new information on the earnings of a stock takes a number of days before it can be completely impounded into the prices of a stock market.
Studies conducted on the experimental financial markets indicate that a majority of individuals are more inclined to overreact when faced with striking, unexpected and new information regarding the stock market. On the other hand, individuals have a tendency to underreact in the face of non desirable or ordinary new information in the same market (8). Consequently, a majority of the researchers in the experimental financial markets have indicated that in the event that one of the aforementioned behavioural designs were to occur, the implication is that the prices of a stock shall assume a mean-reversion trend, following an overreaction on the part of an investor. On the other hand, momentum behaviour is also likely to be observed as a result of an underreaction on the part of the investor. In an explanation that appears somewhat a departure from the tenets of EMH, it has been argued that it is not always that investors in the stock market react uniformly following the news of new information in the market (3). For instance, at times investors have been known to overreact to performance, in the process offloading stocks exposed to recent losses. Alternatively, investors may also overreact by buying those stocks that have experienced recent gains. As a result of these forms of overreaction, the prices of stocks are effectively pushed to a price levels that are by far beyond the ‘rational’ of ‘fair’ value in the market. At the same time, rational investors in the stock market could opt to act in contrast to the irrational behavior of their counterparts. Consequently, stock prices end up back on line, ultimately. One of the major implications of this kind of a phenomenon is that prices of stocks end up getting reversed. In other words, those stocks that realized an upward movement in terms of value will eventually witness a reduction in their value, ultimately. The vice-versa is also true.
On the other hand, the strategies of contrarian investment may as well occur. These are the strategies whereby ‘winners’ are sold while on the other hand, ‘losers’ are purchased. The ultimate goal of such a strategy is to enable inventors earn superior returns on their investment in stocks. Recent data from the US stock market have been used to both test and confirm these two implications. In this case, the returns of the stocks traded on the NYSE (New York Stock Exchange) between 1926 and 1982 were used for computations. In contrast, Lewellen opines that the profitability of stocks due to the contrarian investment strategies are not on their own conclusive enough to dispute EMH since they do not allow for risk while computing (6). There has been contradictory evidence presented by studies done on the EMH. For example, Cenesizoglu and Timmermann reports that for those stocks that recorded low returns in the past, their future returns are more likely to be higher (8). The vice versa is also true. As a result of these findings, contrarian strategies gained immense publicity. On the other hand, such results are in a sharp contrast with the EMH. There are also several anomalies that are documented in literature of stock return predictability, some of which point at a possible under-reaction of the market following new information, while others indicates an overreaction on the same. A number of these research findings bear a correlation with chance (4). However, a further analysis of the data involved would evidently reveal some patterns.
Predictability of stock returns
For over two decades, a lot of evidence has been accumulated in support of the claim that is quite possible to predict stock returns. Lewellen has documented that past returns of a stock market usually have extra information regarding returns that may be expected from the same market in future (6). Owing to the high level of volatility that characterises the stock market, it is quite hard to explain such a market using a model whose rates of discount are constant (8). On the other hand, Fama and French are of the opinion that book-to-market and size are both used to shed more light on the potential cross-sectional variation regarding an average stock (4). Overall, there is compelling evidence to support the claim that there is a variation in terms of the expected returns of a stock over time as well as cross-sectionally. There are several variables that impacts on the predictability of stock returns and they include: the ratio of book-to-market, net share issues, size, and illiquidity ratio. It has been documented that large firms earn less returns in comparison with small firms (8). When the ratio of book-to-market is high, a firm is more likely to realize abnormally higher returns.
The value premium attached to the price of a stock hinges upon the excessive extrapolation by an investor of previous performances of the stock in question, as they attempt to value stocks. Accordingly, this ratio has been categorized as a contrarian indicator. Conversely, rational researchers on the predictability of stock returns argue that value and size are as a result of compensation due to the assumption of systematic risk that had been excluded in the formulation of the conventional assets pricing model (9). Separately, Amihud notes that those stocks that had experienced higher returns in the past experiences end up realizing higher returns, ultimately. A number of behavioural models have thus far been proposed with the intention of offering an explanation to the momentum with respect to either the overreaction or underreaction of an investor, following the release of new information (10). Although there are numerous academic studies supporting the predictability of stock returns, it is important however to examine if at all this form of predictability is symbolic of an efficient stock market. Thus far, this has remained a contentious issue amongst economists and behavioural psychologists alike, as they endeavour to dwell further into the issue of how stock return predictability coupled with an overreaction to the stock market impacts on the theory of an efficient market. According to the explanations offered by behavioural psychologist who have studied stocks, stock predictability is mainly attributed to the misreaction and cognitive biases that investors have regarding information. On the other hand, the pricing theory in rational assets argues that stock return predictability comes about as a result of time varying risk or risk compensation. Sadly, experiential forecasts in support of the two different arguments are usually very similar to the extent that it becomes increasingly difficult to point a difference amongst them, on the basis of the available literature regarding the same.
The hypothesis of an efficient market appears to be the driving force of modern finance. In an efficient market, the price of a stock for example is a depiction of the full information available within such a market. As a result, this acts as a hindrance for shrewd traders to realize abnormal profits at the expense of the other gullible traders. New information in a stock market results in price changes of stock, either upwards or downwards. However, the hypothesis of an efficient market is faced with the challenge of remaining consistent and reliable. Accordingly, there are instances when investors factor in ‘surprises’ in stock earnings while computing future market prices. At other times however, investors may be more inclined to undereact to new information regarding future stocks earnings already accounted for in current earnings.
Various studies have been carried out on EMH but a majority of them appear contradictory. Stocks that realized low returns in the past are noted to realize higher future returns in the future. Conversely, stocks with a history of high return may as well realize low returns in the future. This is a pointer to the level of difficulty surrounding the issue of stock market predictability. Economists and behavioural psychologist have for a long time examined if the predictability of a stock market is symbolic of an efficient stock market. Whereas this still remains a contentious issue amongst the players in the stock market, nonetheless, stock predictability is mainly attributed to the misreaction and cognitive biases that investors have regarding the information available to them.
- A. Brav and J. Heaton. ‘Competing Theories of Financial Anomalies’, Review of Financial Studies, Vol. 15, 2002, pp. 575-606.
- A. Yakov. Illiquidity and Stock Returns: Cross-section and Time-series Effects’, Journal of Financial Markets, Vol. 5, 2002, pp. 31-56.
- B. G. Malkiel, B. G. ‘The Efficient Market Hypothesis and Its Critics’, CEPS Working Paper, No. 91, 2003, pp. 1- 47, Web.
- E. Fama and K. French, K ‘The cross-section of expected stock returns. Journal of Finance, Vol. 47, 1992, pp. 427-465.
- E. Fama and K. French. ‘Multifactor Explanations of Asset Pricing Anomalies’, Journal of Finance, Vol. 51, 1996, pp. 51-55.
- J. W. Lewellen. On the Predictability of Stock Returns: Theory and Evidence, Online, 3000, Web.
- L. Blume and S. Durlauf. The New Palgrave: A Dictionary of Economics, Second Edition. Palgrave McMillan, New York, 2007.
- T. Cenesizoglu A. Timmermann, A. ‘Is the Distribution of Stock Returns Predictable?’,2008, 1-50, Web.
- T. Johnson ‘Rational momentum effects’, Journal of Finance, Vol. 57, 2002, pp. 585 – 608.
- Y Amihud. ‘Illiquidity and Stock Returns: Cross-section and Time-series’, Journal of Financial Markets, Vol. 5, 2002, pp. 31-56.
Amihud, Y. ‘Illiquidity and Stock Returns: Cross-section and Time-series’, Journal of Financial Markets, Vol. 5, 2002, pp. 31-56.
Blume, L. and Durlauf, S. The New Palgrave: A Dictionary of Economics, Second Edition. Palgrave McMillan, New York, 2007.
Brav, A. and Heaton, J. B ‘Competing Theories of Financial Anomalies’, Review of Financial Studies, Vol. 15, 2002, pp. 575-606.
Cenesizoglu, T. and Timmermann, A. ‘Is the Distribution of Stock Returns Predictable?’,2008, 1-50, Web.
Fama, E. and French, K ‘The cross-section of expected stock returns. Journal of Finance, Vol. 47, 1992, pp. 427-465.
Fama, E. and French, K ‘Multifactor Explanations of Asset Pricing Anomalies’, Journal of Finance, Vol. 51, 1996, pp. 51-55.
Johnson, T. ‘Rational momentum effects’, Journal of Finance, Vol. 57, 2002, pp. 585-608.
Lewellen, J. W., On the Predictability of Stock Returns: Theory and Evidence, Online, 3000, Web.
Malkiel, B. G. ‘The Efficient Market Hypothesis and Its Critics’, CEPS Working Paper, No. 91, 2003, pp. 1- 47, Web.
Yakov, A. Illiquidity and Stock Returns: Cross-section and Time-series Effects’, Journal of Financial Markets, Vol. 5, 2002, pp. 31-56.