Contrarian vs momentum
in stock returns
Trading strategies
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Does the Stock Market Overreact
DeBondt and Thaler JF 1985
• Empirical test of overreaction: is it predictable?
• Motivation: overreaction hypothesis
Sample questions
1.What are the major hypotheses in DeBondt and
Thaler (1985)?
2.How are Winner and Loser portfolios formed in
DeBondt and Thaler (1985)?
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Hypotheses
• If stock prices systematically overshoot, then their
reversal should be predictable from past return
data alone
• Hyp1: Price reversal
• Extreme movements in stock prices will be followed by
subsequent price movement in the opposite direction
• Hype2: The more extreme the initial price
movement, the greater will be the subsequent
adjustment
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Test design choice
• 3 types of residuals. Why use market-adjusted
excess returns?
• At least 85 subsequent returns for sample firms.
Why?
• Why 36 months of formation and test period?
4
Test procedures
• Sample: Monthly return data for NYSE common stocks
from CRSP
• Time period: 1926-1982
• 16 non-overlapping time periods
• Portfolio formation period
• Test period
• Winner and loser portfolios: extreme 35 stocks
conditional on excess return behavior prior to
portfolio formation date
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Price reversal
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Seasonality: January effect
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Comment?
• Is there a good trading strategy here?
• Does it hold in other countries?
• Time horizon
• Conflict to momentum strategy?
• Can risk change explain this?
• Size effect?
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Returns to Buying Winners and Selling Losers:
Implications for Stock Market Efficiency
By Narasimhan Jegadeesh
Sheridan Titman
Journal of Finance 1993
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Table 1 Returns of
Relative Strength
Portfolios
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Section III Sources of Relative Strength Profits
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Table 3 Control of Risk or Size
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Part of the predictable price changes that occur during 3to 12- month period may not be permanent. Table 7
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Seasonal
patterns
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Table IX Quarterly Earnings Announcement Date Returns
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Table IX findings
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Conclusion and Discussion
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A Unified Theory of Underreaction, Momentum
Trading and Overreaction in Asset Markets
Harrison Hong and Jeremy C. Stein
JF 1999
• Unified account of under- and over-reaction
• Two groups of boundedly reational agents: Newswatchers and momentum traders
• Slow information diffusion across the population è
price underreact in the short run
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PROC EXPAND Procedure
*Compute
cumulative returns;
proc expand data=crsp (keep=CUSIP date ret) out=umd method=none;
by CUSIP;
id date;
convert ret=msum_return / transformout=(MOVSUM
&J);
convert ret=c_ret1 / transformin=(+1) transformout= (MOVPROD 6 );
convert ret=c_ret / transformin=(+1) transformout=(MOVPROD 6 -1 trimleft 6);
label cum_return = "cum_return";
quit;
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Computing Beta
proc reg data=aa
tableout outest=regout EDF noprint;
by cusip fdate;
model ret_rf=Mkt_RF;
model ret_rf=Mkt_RF SMB HML;
/*******
https://en.wikipedia.org/wiki/Fama%E2%80%93French_threefactor_model
https://mba.tuck.dartmouth.edu/pages/faculty/ken.french/dat
a_library.html
*******/
quit;
data estimate;
set regout (keep=cusip fdate _MODEL_ _TYPE_ _EDF_
Intercept Mkt_RF SMB HML _RSQ_);
where _TYPE_="PARMS";
drop _TYPE_;
*
rename Intercept=alpha Mkt_RF=beta;
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proc sql;
create table check1 as select unique cusip, year(date)
as year, qtr(date) as q,
count(distinct CUSIP) as
CUSIP, count(RET) as n, mean(RET) as RET
from a.Crsp_mth
where year(date)>2022
group by cusip, year(date), qtr(date);
quit;
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Mini project 2 Market reactions
Due: 11:30pm, Feb 19
• Components: Executive summary, sample selection and
data, methodology, main table / figure, analysis and critical
thoughts.
• Topics:
• Paper replication of Huang and Li (2014)' main table, or
• Paper replication of Bai and Ru (2024) ' main table, or
• Does stock market react to analyst forecasts?
• Momentum or contrarian trading strategy
• Format: Within 4-7 pages, single spaced
• Submit a Word file and a file of SAS codes.
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