Distinguishing between Rationales for Short-Horizon Predictability of Stock Returns
Posted: 24 Nov 2004
In this paper, we shed light on short-horizon return reversals. We show theoretically that a risk-based rationale for reversals implies a relation between returns and past order flow, whereas a reversion in beliefs of biased agents does not do so. The empirical results indicate that returns are more strongly related to own-return lags than to lagged order imbalances. Thus, the evidence 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 cross-sectionally related to lagged imbalance innovations at horizons longer than a month.
Keywords: Market efficiency, order imbalance, trading activity
JEL Classification: G12, G14
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