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Overreaction Hypothesis in the UK Stock Market sample essay

The Stock market movements are often influenced by the availability of information on the various securities that is being dealt with in the market. Depending on the information flow, the stock’s price moves up and down reflecting the mood of the market. Under an efficient market, since the stock prices already represent the available information, they will move only when new, unexpected information becomes available. The movement of the stock prices is largely determined by the relative merits and demerits of the information and how it is going to affect the performance of the company which the stocks represent.

Just the same way the predictability of the information is impossible as to whether it is good or bad, it is equally impossible to predict the direction in which the stock prices will move in the future based on such information. Generally it is assumed that it is not necessary for everyone in a financial market to be well informed about a security and also that all the participants should have the ability to perceive, analyze and use the information to their advantage. All the efficient market requires is that a few people have the information and based on the information of the few people, the entire market will be well informed. Thus the efficiency of the market is determined purely on the basis of the availability of the information.

Efficient Market Hypothesis

Robert C. Higgins (1992) aptly describes the market efficiency in clear terms. According to him market efficiency is a concept that deals with the reaction of the competitive markets with respect to the prices on the basis of new information received. He has equated the arrival of the new information in the market as lamb chop thrown among flesh-eating piranha where the investors can be identified as the piranha. At the moment the lamb-chop hits the water there will be a rush of the piranha to get the share of each. Once the meat is taken away by them and the bone is left there will be no activity around the place and normalcy will return. Similarly at the time new information reaches the market, the investors throng the market to react positively or negatively and buy and sell securities depending on the news, which leads to major changes in prices. The moment the prices are adjusted for the information received the information becomes worthless bone and left untouched. Any further reaction on the information will not yield any new intelligence and cause changes in prices.

Efficient Market Theory

The efficient market theory states that “prices of securities in financial markets fully reflect all available information”. (Mishkin, 1997) Thus market efficiency can be defined as the degree to which the market reacts to any new information in a precise manner in respect of the share prices. This theory gives rise to the phenomenon of an ‘Efficient market Hypothesis’ which describes a position in which the stock prices react fully and immediately based on the information received. The underlying assumption is that every investor will get an equilibrium return. This implies that no investor can expect to make an abnormal profits by doing a fundamental or technical analysis. This hypothesis implies that “if new information is revealed about a firm it will be incorporated into the share price rapidly and rationally, with respect to the direction of the share price movement and the size of that movement”. (‘elearn’ –NetTel)

In any case stock market efficiency does imply that the investors are in possession of precise predictive powers. The concept postulates the theory that the current stock market price levels is an almost reliable accurate estimate of the economic value which is dependent on the information reaching the market.

Types of Market Efficiency

To understand the concept clearly, market efficiency can be synthesized into:

• Operational Efficiency: refers to the transaction cost resulting to the buyers and sellers dealing in a stock exchange.

• Allocation Efficiency: implies the ability to allocate the available resources of the society among competing investment opportunities which are real

• Pricing Efficiency: enables the individual to earn just a return which is adjusted to the risk factors involved. This is so because the prices tend to move instantaneously and directly to the news received.

Need for Market Efficiency

The Stock Market should be efficient for discharging the following values expected of the market:

• To Ensure Proper Pricing of Securities and thereby to encourage the trading in the shares and other securities

• To enable company managers take sound financial decisions by giving correct signals to them

• To help in an efficient allocation of resources based on the operating efficiency and the pricing efficiency by providing timely information on the securities

Levels of Market Efficiency

• Weak-Form Efficiency- where the share prices fully reflect all information which were revealed by past price movements of the shares. This form of efficiency will not do any good to the investor as the future cannot be predicted on the basis of the historic price data.

• Semi-Strong Form Efficiency-where the share prices fully reflect all the relevant information which are publicly available like announcements on the profits and dividend payments, issue of rights shares, technological advancements, changes in the board of directors etc. along with the past price movements of the shares

• Strong-Form Efficiency-where all relevant information including those privately held is reflected in the price. In this form of efficiency ‘Insider Trading’ plays a vital role, in which a few privileged individuals like director or other senior executive of a company who is in possession of a valuable information (positive or negative) about the company and uses it to take a personal profit by trading in the company’s shares.

Reflections of an Efficient Stock Market on the Securities Trading

According to Efficient Market Hypothesis at any specific point of time, the prices of securities in the stock market fully reflect all available information. The Efficient Market Hypothesis implies that the while individuals buy and sell securities on the assumption that the worth of the securities are more or less than the price the market offers. The important point here is that if the markets remain efficient and the current prices react fully to the information received, then the trading in securities becomes a game of chance rather than an expertise to deal with the sole aim of outperforming the market. This is so because there are various other factors which have a direct or indirect influence on the stock prices and which affect the movements of the prices upwards or downwards based on their effect on the buying or selling moods of the investors.

While the Efficient Market Hypothesis generalize the situation of stock price movements, technical analysis like moving averages and Support and Resistance techniques have tried to provide some scientific bases to predict the reactions of the stock prices.

The efficiency of the stock market operation has its own reflections on the trading in securities both from the angle of the investor and the company whose shares are being traded. As it is implied that the news received may not be used to result in abnormal profits, the average investor should decide on a particular portfolio with the minimum cost of trading and base his decision on a host of information which are timely and valuable to make the otherwise efficient market to his advantage. The entities should be backed by the pressure from the investors, various standard setting bodies, legislations from the government and the stock market rules to make available as much information as possible to enable the stock market to react sharply and accurately to ensure a proper pricing.

Over Reaction Hypothesis

The efficient market hypothesis has been considered to be the central theme of financial management relating to stock markets for more than three decades. Fama (1970) defined an efficient financial market as one in which security prices are affected on the basis of available information. However there are contradicting view points from behavioral theorists like Daniel, Hirshleifer and Subrahmanyam (1998) Barberies, Shleifer and Vishny (1998) argue that the financial markets cannot act efficiently due to overreaction and under-reaction of the investors.

Encarta defines overreaction hypothesis as “the theory that investors react too extremely to events causing price movements that exceed expectation and necessitate price corrections”. (Encarta) Overreaction hypothesis is a market phenomenon which states that the investors and traders react disproportionately to new financial information about a given security. This will result in a drastic change in the price of stocks. As a consequence the stock price may not reflect the true value of the security immediately after the event. In any case the price variations due to overreaction cannot last long. The stock prices will return to its true value after some time. (Investopedia)

Thus in equity markets where the stock prices react efficiently to market news and information the investors may not be able to predict the future returns and abnormal profits. However there have been conflicting views that the markets cannot react efficiently to the market information. DeBondt and Thaler (1985) for instance demonstrated that investors would be able to earn abnormal profits in the long run using the historical market information on the stock market returns. They have observed that in the course of long run a portfolio which consist stocks that have performed extremely poor in the past and portfolio that have performed very well in the past would be able to produce abnormal profits by selling or buying stocks. The authors argue that these profits which are known as ‘contrarian’ profits are due to the investor reactions of optimism and pessimism which are described as investor overreaction of the investors to the information.

Another specific consequence of overreaction is the profitability of contrarian portfolio strategy. This strategy exploits negative serial dependence in asset returns in particular. Purchase of securities which have performed poorly in the past and sale of securities which have performed well are the defining characteristic features of a contrarian strategy. “Selling the “winners” and buying the “losers” will earn positive expected profits in the presence of negative serial correlation because current losers are likely to become future winners and current winners are likely to become future losers” (Benou et al, 2003) From this it can be observed that one of the implications of stock market overreaction is positive expected profits. This is according to the contrarian investment rule. It is the apparent profitability of several contrarian strategies which has made several researchers to conclude that the stock markets indulge in overreaction.

DeBondt and Thaler (1985) studied the behavior of stock market investors and based on their study concluded that individuals tend to show an overreaction on the basis of recent financial and other information and do not attach much importance to the past data. The study was to find out the effect of such behavior on the stock market price levels. They have found that those stocks which were performing poorly in the past three to five years tend to show an outstanding performance in the subsequent three to five year period thus outperforming the prior period winners. The results indicate that the investors are found to be oversensitive to the financial news affecting the stock markets and this kind of behavior is called as ‘overreaction’.

The overreaction hypothesis as advocated by DeBondt and Thaler suggests that since the investors realize about their overreaction, extreme movements in stock prices are normally followed by the prices which necessarily move in the opposite direction. Moreover if the initial price movements are more pronounced then the subsequent reversals are of same or greater magnitude.

While there is a lot of research works which could predict the returns due to overreaction, no consensus has been evolved about this predictability. Zarowin (1990) and Baytas and Cakcicin (1999) observe that the overreaction may at best be described as an effect caused by part manifestation of the size effect on the stock market. According to Zarowin (1990) when the losers are smaller in numbers they normally outperform winners and when the winners are less in numbers the converse becomes true and the winners outperform the losers. Thus the study by Zarowin (1990) arrives at a conclusion that the losers tend to outperform winners due to the fact that the loser firms are in a majority cases are smaller than those which win.

The study by Chopra, Lakonishook, and Ritter (1992) based on an empirical analysis found an economically significant overreaction effect that does not depend on the size or beta. The overreaction effect reported by this study indicated that the overreaction effect is much more in the case of smaller firms rather than larger firms. Hence this study proposed the hypothesis that while institutions and other dominant stock holders do not react much, individuals who are predominantly the holders of stocks in smaller firms react more to financial information.

Cox and Patterson (1994) observe that in less liquid markets there is bound to be stronger reversals if the liquidity is an important factor in the stock market reversal process. This will also be the case with smaller firms and the degree of reduction in the reversals over a longer period of time. However if the overreaction of the investors is assumed to be the cause of the reversal, then a greater reversal can be expected in the market if there was a greater one-day decline in the market. As per the studies conducted in this direction, significant reversals have been observed over the period from day one through day three. Similarly the reversals show a decreasing trend over the period of time and this result is also consistent with the earlier findings in this topic.

Authors like Conrad and Kaul (1993) argue that the effect of overreaction may be due to the spread between asking and buying rates and also due to the infrequency in trading. They have also found that smaller firms show the tendency to reverse more than the larger firms. The results of their study do not indicate a large scale reversal due to larger initial declines and hence they do not support the overreaction hypothesis. There are some other studies which present an argument that the long-term mean reversal in stock returns might be mostly due to the errors in the risk measurement techniques (Chan, 1988; Ball and Kothari, 1989)

Another way in which the overreaction hypothesis was analyzed used the behavior of stock returns following large declines in the stock prices. For instance Brown, Harlow and Tinic (1988) have observed the trend of a reversal phenomenon. Alternatively they have suggested an uncertain information hypothesis.

Jagadeesh and Titman (1995) observed a major role of liquidity in the stock price reversals. Their study was based on the reactions of the stock prices to common factors as well as firm-specific information. They observed that the stock prices react slowly with a delay to the common factors affecting the market while the firm specific information makes the stock prices to overreact. While stock market overreaction can be attributed as the main reason for reversal of firm specific component of returns a more plausible explanation can be found in the price pressure generated by traders who are motivated by the liquidity factors.

Disanaike (1997) used samples of larger and well known UK companies to investigate the phenomenon of stock market overreaction on the stocks of such companies. The analysis by the author was from the perspectives of the size effect, bid-ask biases and infrequent trading and the impact of these factors on the stock prices. The study concluded the overreaction hypothesis and concurred with the previous findings that time-varying risk does not seem to have any effect on the stock price reversals.

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