Noise Trading, Slow Diffusion of Information, and Short-Term Reversals: A Fundamental Analysis Approach
43 Pages Posted: 10 Jan 2018 Last revised: 17 May 2018
Date Written: May 10, 2018
Contrary to the conventional wisdom that short-term return reversals are rooted in investors’ overreaction to fundamental news or driven by liquidity-based noninformational shocks alone, we find strong evidence that both noise trading and investor underreaction to fundamental information contribute to the reversal. With help from a comprehensive and nonparametric measure of firms’ fundamental strength, we document that an enhanced short-term reversal strategy that buys past losers with strong fundamentals and sells past winners with weak fundamentals significantly outperforms the unconditional reversal strategy. Our findings are consistent with the predictions of theoretical models where investors underreact to slowly diffusing fundamental information.
Keywords: short-term return reversals, fundamental analysis, investor underreaction, slow diffusion of information
JEL Classification: G11, G12, G14
Suggested Citation: Suggested Citation