Momentum and Reversal: Disentangling the Underreaction and Delayed Overreaction

Abstract

I propose a nested hypothesis test of competing mechanisms that explain return momentum and reversal using seemingly opposite biases: underreaction or delayed overreaction in investors' expectations of cash flows. Using analysts' forecasts as a proxy for these expectations, this study traces the errors of the continuously updated expectations over a 24-month holding period in which returns are characterized by a momentum phase followed by a reversal phase. Empirically, I find strong evidence for underreaction in cash-flow expectations and little evidence for delayed overreaction. These results provide new insights on the determinants of momentum and reversal and lead to novel implications that are tested in this paper.

Keywords: cash flow expectations, momentum, reversal, underreaction, overreaction, earnings forecast

JEL Classification: G12