Decomposing Short-Term Return Reversal
University of Notre Dame - Mendoza College of Business
University of Hawaii at Manoa - Shidler College of Business
Federal Reserve Banks - Federal Reserve Bank of New York
August 25, 2011
The profit to a standard short-term return reversal strategy can be decomposed analytically into four components related to (1) across-industry return momentum; (2) within-industry variation in expected returns; (3) underreaction to within-industry cash flow news; (4) and a residual. Only the residual component, which isolates reaction to recent "non-fundamental" price changes, is significant and positive in the data. A simple short-term return reversal trading strategy designed to capture the residual component generates a highly significant risk-adjusted return three times the size of the standard reversal strategy during our 1982-2009 sampling period. Our decomposition suggests that short-term return reversal is pervasive, much greater than previously documented, and driven by investor sentiment on the short-side and liquidity shocks on the long-side.
Number of Pages in PDF File: 44
Keywords: return reversal, liquidity, cash flows, discount rate
JEL Classification: G12working papers series
Date posted: February 12, 2010 ; Last revised: August 30, 2011
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