Behavioral Finance Economics 437

Significance of Fama-French Blew up “beta” as predictor of Exp Returns Provided a simple rule for investing success Seems to contradict Semi-Strong EMH Made “respectable’ earlier work that provided simple, but successful investment rules DeBondt and Thaler, for example

DeBondt-Thaler 1984 “Over-Reaction” Hypothesis Suggests that: After a period of “over-reaction,” markets “revert” back and go the other way. Stocks that have done well in the past, do poorly in the future Stocks that done poorly in the past, do well in the future Their article is designed to test whether or not “mean reversion” is true.

Data NYSE data Begin with three year lookback in Dec 1932 Jan 1926 through December 1982 Monthly return data Begin with three year lookback in Dec 1932 Monthly data from Jan 1930 through Dec 1932 36 months or three years data Form portfolios of L(osers) and W(inners) Then see how they do for the next three years

DeBondt and Thaler: “Does the Stock Market Overreact” (1985) L – three year loses W – three year winners Question: How do the W’s do in the next three years? How do the L’s do in the next three years? Other things worth noting Almost all of the impact is in January When the W portfolios are formed, they have very high P/E ratios, the L portfolios have low P/E ratios at the time of formation

DeBondt-Thaler conclusions Definite evidence of mean reversion (a form of serial correlation): L portfolios consistently outperform W portfolios 19.6 % better than the market after end of 3 years W portfolios consistently underperform the market 5 % less than the market after end of 3 years

Interesting facts Most of the excess returns are in January Loser effect more pronounced: Losers earned 19.6 % more than the market Winners earn 5.0 % less than the market Loser portfolio minus Winner portfolio return = 24.6 %!!!!! Most of the return difference is during 2nd and 3rd year Larger loses become larger winners; larger winners become larger losers

Ball & Brown 1986 Market “underreacts” to earnings surprises Article generally ignored until Jagdeesh-Titman Time span suggests that Ball-Brown effect may be the same thing as Jagdeesh-Titman

Jegadeesh and Titman (1993) Relative strength strategies, sometimes called “earnings momentum” strategies Find past winners and and past losers (using 3 to 12 month holding periods) generate gains (winners gain; losers lose) Construct W portfolio and L portfolio W-L (using 6 month periods) earns more than12 % better than market portfolio Longer term portfolios do best in next 12 months Interpretation in “event time” Doesn’t work in January

Chan, Jegadeesh, Lakonishok 1996 Is it earnings? Is it price? They 7.7 percent six month gap between winner portfolios and loser portfolios using price momentum. Conclusion (page 1709): “ In general, the price momentum effect tends to be stronger and longer-lived than the earnings momentum effect.”

Chordia-Shivakumar, 2006 Is it “pricing momentum” or “earnings momentum” that drives the “under-reaction” phenomenon? Conclude the earnings momentum is the key factor. Price momentum variables are a “noisy proxy” for earnings momentum

Hong, Lee & Swaminathan 2003 Earnings Momentum is the real driver of price momentum Systematic relationship between earnings momentum and future GDP growth – hence a “risk factor” This matters, because if there is a risk factor, then momentum might be consistent with EMH (which price momentum generally is not)

The End