Do U.S. Stock Market Indexes Over‐ or Underreact?

Abstract

Our objective is to investigate the short-term over-or underreaction of six U.S. stock market indexes. We find evidence of a one-day underreaction for winners (days on which an index experiences abnormally high returns) and losers (days on which an index experiences abnormally poor performance). We also find strong evidence of a sixty-day underreaction for winners. For losers, abnormal returns turn from negative to positive as the period is extended, resulting in significant reversals over the sixty-day period. Results are generally consistent for each of the six indexes. Overall, these results provide strong support for the uncertain information hypothesis. JEL classification: G14 I. Contribution and PurposeVarious studies address overreactions in equity markets and the subsequent reversals of these excessive reactions. The term "overreaction" implies a reaction larger than one considered normal in light of a simultaneous information release. In a statistical sense, a normal reaction involves a revision of probabilities in accordance with Bayes' rule. Thus, overreaction violates the basic statistical principle that the extremeness of predictions must be moderated by considerations of predictability; a larger weight than called for by Bayes' rule is attached to the most recent information. This is called the overreaction hypothesis.In equity markets, an overreaction implies a larger share price reaction (in absolute terms) to recent news than would occur if investors revised their beliefs regarding future expectations rationally in accordance with Bayes' rule. That is,The authors would like to thank Rob Hansen (previous JFR editor), an anonymous JFR reviewer, Marilyn Wiley (Florida Atlantic University), and Emilio Zarruk (Florida Atlantic University) for their helpful comments and suggestions. Participants at the 1998FMA Doctoral Consortium also provided many valuable insights, especially Kent Daniel (Northwestern University).

Investors Reaction to Market Surprises on the Indian Stock Exchange and Currency Markets

“…In the case of good news (favorable events),CARs for the MSE index exhibit the same pattern of increases as for bad news but in a less dramatic fashion and the increases do not attain Therefore, the empirical results presented here provide strong support for the predictions of the UIH for both good and bad news in the case of both MSE index and the pattern in the currency market consistent with Schnusenberg and Madura (2001) and Ajayi etal. (2006)'s studies for US market, but statistically significant only in the case of bad news.…”

Short-term under/overreaction, anticipation or uncertainty avoidance? Evidence from India

“…They claim that this underreaction is still unaccounted for after the usual risk-factors, calendar effects, and bid-ask biases are considered. Their interpretation is that investors process extreme negative news optimistically and extreme positive news pessimistically, an idea raised in the past (Schnusenberg and Madura, 2001). Lasfer et al (2003) also document short-term underreaction following both positive and negative news.…”

Reexamining the uncertain information hypothesis on the S&P 500 Index and SPDRs

“…Combined with supporting or contradicting public information announcements, strategies developed from the UIH have proven to be potentially profitable (Fehle and Zdorovtsov 2003). Further research has been applied to individual stocks (Cox and Peterson 1994), domestic stock indexes (Schnusenberg and Madura 2001) and foreign stock indexes (Ajayi and Mehdian 1994).…”

“…Price movements following positive events in the US market (represented by the Dow Jones Industrial Average) show a pattern consistent with the overreaction hypothesis. Schnusenberg and Madura (2001) use the best and worst performing days in the history of six U.S. stock indexes to form winners and loser portfolios. They find evidence of a one-day underreaction for winner and losers.…”