1. Behavioral Finance
Economics 437

2. 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

3. 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.

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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.”

11. 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

12. 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)

13. The End