On Distinguishing between Rationales for Short-Horizon Predictability of Stock Returns
54 Pages Posted: 28 Sep 2003
Date Written: October 1, 2003
In this paper, we shed theoretical and empirical light on short-horizon return reversals. We provide a model of price formation where risk averse agents absorb the order flow from outside investors. This framework captures both behavioral and inventory effects, and allows us to obtain analytical implications for the conditions required to obtain reversals in returns. Key to distinguishing between inventory and overreaction explanations for such reversals is the role of order flow. The inventory rationale requires a relation between returns and past order flow, whereas a reversion in beliefs of biased agents can cause reversal in returns independent of order flow. Our theoretical analysis further implies that lagged returns dominate lagged order flows in explaining current returns only if belief reversion is the dominant driver of return reversals. The empirical results indicate that, at monthly horizons, current returns are more strongly related to lagged returns than to lagged order imbalances. This suggests that monthly reversals are not completely captured by inventory effects and may be driven, in part, by belief reversion. We do find that returns are related to lagged imbalance innovations at horizons longer than a month. Finally, while the statistical significance of the reversal is quite strong, its magnitude is modest enough to not present substantial profit opportunities for individual investors.
Keywords: microstructure, market efficiency, behavioral finance
JEL Classification: 027
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