Decomposing Short-Term Return Reversal
44 Pages Posted: 12 Feb 2010 Last revised: 30 Aug 2011
Date Written: 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.
Keywords: return reversal, liquidity, cash flows, discount rate
JEL Classification: G12
Suggested Citation: Suggested Citation