About Financial Markets React
The title of this essay comes from a famous research paper in the Journal of Finance, July 1985 “Does the stock market overreact? The authors were Werner DeBondt and Richard Thaler. The work is very suitable for what is happening to world stock markets in the months of July and August 2007. The test gives us valuable information on the nature and behavior of markets, so a little research on its content.
Probably many of us have felt at some point, some over-reaction to market news or events. For example, after the attack on the Twin Towers in New York on September 11, 2001, markets were minimal scoring for six consecutive days after reopening to then bounce vigorously and take it all in just one calendar month.
Again facing a terrible news such as the American credit crisis (USA), markets overreact apparently dropping almost a worrying 8% in about two weeks.
Can we be assured that this is just another over-reaction or indeed the world are on the brink of collapse and affirmed the two former executives of the firm Bear Stern, recently retired (quit claim), the debacle of three their Hedge Funds?
The statistical evidence indicates that market effectively if over-react and this is precisely what the study shows De Bondt and Thaler.
Which authors based evidence for this conclusion?
First, scholars speak of the empirical evidence that human beings tend to give more weight to recent data, while downplaying or completely ignores the long-term trends. If so, then we should be able to demonstrate that companies with new and good news tend to pay above the market average while companies with new bad news but yield less than average.
This is not difficult to prove and to an outcome seems intuitive enough for our purpose but we do not show more information. After a period of 5 years or more, the former portfolios now the losers are winners and losers or winners are now overdue. Thus it can be shown that over-react to news stories and ignore long-term trends, investors’ portfolios winners become losers and losers into winners:
“When Investors overreact to new information and ignore long-term trends, regression to the mean the average winner turns Into a loser and the winner Into The average loser.”
Note that this mechanism operates in the effect of “mean reversion” which have spoken on other occasions. As explained so far, we can infer the following implications and deductions:
- In the long term “mean reversion” if it works for well-constructed portfolio. But I insist, as I explained in other trials, that “mean reversion” as short-term strategy is dangerous and counter-productive results.
- If the “mean reversion” will not operate in the long term, then the portfolio would still be winners all winners and losers of life will vanish from the map. At the end leaving a single company with a monopoly on all economic activities and we know that this is not possible. There is thus a very marked trend in the financial markets experiencing successive periods of expansion and contraction.
- The “random walk” (Random Walk) and “mean reversion” are mutually exclusive. If markets are perfectly random as some insist, then we can not expect to happen the effect of reversal, but the latter is demonstrated statistically.
As an example we review a study by Morningstar in the year 1994 with a portfolio of different asset classes in periods of 5 years:
We can see from the chart performance of portfolios composed of different asset classes over five years ending in March 1989 and March 1994.
They observe that portfolios with higher than average yields, then were relegated for the next 5 years, thus confirming the findings of De Bondt and Thaler in his famous study.
The current credit crisis is, in my view, an incredible over-reaction: the markets will not collapse as expected by some as the fundamentals are strong and healthy. This in a market of relatively low inflation around 3.2% and with a P / E, price to earnings ratio of S & P 500, 16.5, fairly low value on their history.
It’s time to take some advantages. The financial component of the S & P 500 (XLF) performed on a minimum of 32. I rather doubt that we will see this bargain.
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Tags: economic activities, financial component, Financial Markets, Journal of Finance