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Trees Do Not Grow to the Sky: Reversals in a Stock Market

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Price-Based Investment Strategies

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Abstract

While the momentum strategy assumes the continuation of the price movement, the reversal strategies rely on a contrary assumption: predicting the price trend to revert. How can both the phenomena coexist? The solution is the investment horizon. While the momentum effect arises in the mid-term (3–12 months), the reversal occurs either in the short term (1 month) or in the long term (3–5 years). This chapter thoroughly discusses both the sources and implementation of reversal strategies in financial markets. The authors also showcased various improvements to the reversal strategies providing vast theoretical and empirical evidence in their support. Finally, they individually tested the reversal techniques across 24 different equity markets.

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Notes

  1. 1.

    The examples include Jacobs (2015, 2016), Zaremba and Szyszka (2016), Zaremba (2016, 2016d, 2017), Hou et al. (2017), and Jacobs and Müller (2017a).

  2. 2.

    See, for USA, Campbell and Limmack (1997), Dissanaike (1997); for UK, Clare and Thomas (1995); for Spain, Alonso and Rubio (1990), Forner and Marhuenda (2003); for Germany: Stock (1990); for New Zealand, Swallow and Fox (1998); for France, Bacmann and Dubois (1998); for Poland, Sekuła (2015); for Australia, Brailsford (1992); for Canada, Kryzanowski and Zhang (1992); for Brazil, Da Costa (1994); for Malaysia, Ahmad and Hussain (2001) and Ali et al. (2011); for China, Wu (2011); for Sri Lanka: Tripathi and Aggarwal (2009); for Tunisia, Dhouib and Abaoub (2007); for South Africa, Page and Way (1992) and Hsieh and Hodnett (2011); for Turkey, Bildik and Gulay (2007); for Jordan, Saleh (2007); and for Egypt, Ismail (2012).

  3. 3.

    See, for stocks, Alonso and Rubio (1990), Da Costa (1994), Baytas and Cakici (1999), George and Hwang (2007), Saleh and Sabbagh (2010), and Maheshwari and Dhankar (2015); for equity country indices, Richards (1997), Balvers et al. (2000), Balvers and Wu (2006), Spierdijk et al. (2012), Smith and Pantilei (2013), Malin and Bornholt (2013), Gharaibeh (2015), and Zaremba (2016d); for currencies, Chen and Jeon (1998), Sweeney (2006), Serban (2010), Chan (2013), and Kumar (2014); for futures markets, Monoyios and Sarno (2002), Chan (2013), and Lubnau and Todorova (2015); for government bonds, Park and Switzer (1996) and Khang and King (2004); for commodities, Irwin, Zulauf, and Jackson (1996), Andersson (2007), Miffre and Rallis (2007), and Chaves and Viswanathan (2016); for corporate bonds, Bhanot (2005) and Bali et al. (2017); and for industries, Bornholt et al. (2015).

  4. 4.

    The two anomalies have been initially described in seminal papers of Basu (1983), Banz (1981), and Rosenberg et al. (1985). A comprehensive discussion and review of literature could be found in Zaremba and Shemer (2017).

  5. 5.

    For further discussion of the relationship between size and long-run reversal, see Zarowin (1989, 1990).

  6. 6.

    These issues have been also discussed and are partially sourced from Zaremba and Shemer (2017).

  7. 7.

    For further explanation of the concepts of loss aversion and mental accounting, see Szyszka (2013).

  8. 8.

    This observation was later confirmed for the international markets by Chaves et al. (2012). On the contrary, Chui et al. (2013) found the behavior of the value premium consistent with the risk-based explanation but failed to support the mispricing hypothesis.

  9. 9.

    For further discussion, see also Fama and French (1996).

  10. 10.

    See Kang and Kang (2009), Avramov et al. (2013), Elgammal and McMillan (2014), Janssen (2014), Choi (2013), or Blitz et al. (2014b).

  11. 11.

    The importance of human capital in explaining the value premium was also the subject of investigations by Hansson (2004), Santos and Veronesi (2006), Jank (2014), and Sylvain (2014).

  12. 12.

    For further discussion, see also Carlson et al. (2004) and Cooper (2006).

  13. 13.

    For further discussion on this issue, see Ferson and Harvey (1994), Erb et al. (1995, 1996a, b), Bekaert et al. (1996), Dahlquist and Bansal (2002a), Harvey (2004), Andrade (2009), and Zaremba (2016b, c).

  14. 14.

    See, for example , Zarowin (1990), Pettengill and Jordan (1990), Jegadeesh (1991), Chopra et al. (1992), and Conrad and Kaul (1993).

  15. 15.

    Importantly, it may influence not only stock returns but also, for example, funds. See, for example, Carpenter and Lynch (1999) for discussion.

  16. 16.

    For other studies reviewing a large number of anomalies, see Hou et al. (2011, 2015, 2016), Green et al. (2016), Jacobs and Müller (2017a, b), Zaremba (2016, 2017), Zaremba and Nikorowski (2017), and Zaremba and Andreu Sánchez (2017).

  17. 17.

    See also McLean and Pontiff (2016) and Jacobs and Müller (2017a).

  18. 18.

    Campbell et al. (1993), Ball et al. (1995a), Conrad et al. (1997), Da and Schaumburg (2007), Avramov et al. (2006a, b), Huang et al. (2010), de Groot et al. (2012), Nagel (2012), Da et al. (2011, 2014a), and Cakici and Topyan (2014).

  19. 19.

    We should admit here the existence of some evidence casting doubt on the presence of the short-term reversal effect. In particular, in less developed and frontier markets the short-term reversal effect tends to transform into short-term continuation (Zaremba and Szyszka 2016; Zaremba and Czapkiewicz 2017; Zaremba 2017).

  20. 20.

    See, also, Wei (2011).

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  1. Poznan University of Economics and Business, Poznan, Poland

    Adam Zaremba

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    Jacob “Koby” Shemer

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Zaremba, A., Shemer, J.“. (2018). Trees Do Not Grow to the Sky: Reversals in a Stock Market. In: Price-Based Investment Strategies. Palgrave Macmillan, Cham. https://doi.org/10.1007/978-3-319-91530-2_3

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