Testing the Overreaction Hypothesis in the UK Stock Market by Using Inter & Intra Industry Contrarian Strategies

Abstract:     
This study mainly supports the Overreaction Hypothesis in the Inter-industry and the intra-sector environment of the UK stock market. Firstly, it contradicts Haugen, (1996) plausible hypothesis that long-term reversals should not exist when value-weighted industry indexes are used in order to find it. Secondly, it is opposite to Kothari et al. (1995) results that long-term reversals are a result of the survivorship bias. Thirdly, our inter-industry results do not support the argument that the size effect is the main reason why long-term reversals occur in the stock market. Fourthly, the volatility tests do not support the claim that the excess profits coming from this inter-industry contrarian strategy are a risk premium. After all, if these excess inter-industry contrarian profits where truly a risk premium then losers should constantly be riskier in all volatility tests we ran. Fifthly and most importantly, our study supports the hypothesis that the inter-industry contrarian strategy using equally-weighted winner-loser portfolios consisted of value-weighted industry indexes leads to lower contrarian profits than these of the intra-industry contrarian strategy that uses equally-weighted winner-loser portfolios consisted of stocks. Possibly, the former strategy captures a lower level of arbitrage risk and a smaller dispersion of heterogeneous beliefs than the latter strategy does. Sixthly, our study supports the hypothesis that the further (less) investors look stock prices in the past, the more (less) they overreact to them creating higher (lower) long-term reversals. Both last hypotheses (five, six) support the main prediction of the overreaction Hypothesis.

Number of Pages in PDF File: 79

Keywords: Market Overreaction, Market Efficiency, UK Equities Market, Behavioural Finance

JEL Classification: G10, G14

working papers series