Overreaction effect: evidence from an emerging market (Shanghai stock market)

Abstract

PurposeThe purpose of the study is to examine overreaction effect in the Chinese stock market after the global financial crisis (GFC) of 2007 for all the stocks listed in Shanghai Stock Exchange (SSE) Composite 50 index.Design/methodology/approachTo capture overreaction effect in the stock listed at SSE 50 Index, a time series analysis of average cumulative abnormal return within a unified framework is applied for the period of January 2009 to December 2015. From these loser and winner portfolios, contrarian strategy is applied to build arbitrage portfolio, which is the difference of mean reversions between loser and winner portfolios. The portfolio construction is based on a 12-month formation period and 6-month testing period for intermediate-term analysis and. for short-term analysis, 6 month formation and 3 month testing periods. The authors also applied regression analysis to test a return reversal effect for the sampled period.FindingsResults show that contrarian strategy yields positive excess returns for the arbitrage portfolio for most of the testing periods. The intermediate baseline case shows the arbitrage portfolio producing an average excess return of 14.1%, while even the short-term one produces 4%, which is statistically significant at the 5% level. The study finds asymmetrical overreactions in the SSE especially for loser portfolios. The biggest winner and loser portfolios follow the mean reversal effect. Moreover, before-after test for the biggest winner and loser portfolios shows that the losers recovered and beat the market immediately.Practical implicationsThe study could benefit government, policy makers and regulators by studying how presence of more individual investors than institutional investors of China stock market leads to more irrational decisions giving rise to volatility. The regulators could build favourable policies for institutional investors to give them incentive to invest more than individual investors through which market volatility could be controlled.Originality/valueThis research contributes to market behaviour research, showing how working under hypotheses of overreaction; gains can be made with contrarian investment strategy through arbitrage portfolios. The authors provide specific additional support for the short and medium-term overreaction in the SSE for the period 2009–2015 using regression analysis.Contribution to ImpactThis research contributes to market behaviour research, showing how working under hypotheses of overreaction; gains can be made with contrarian investment strategy through arbitrage portfolios. We provide specific additional support for the short and medium-term overreaction in the SSE for the period 2009–2015 using regression analysis.

Comparative Analysis of Market Overreaction in Indonesia and Singapore Stock Exchange 2016-2019

“…The findings indicate that there is an overreaction, especially for the loser portfolio in the short term. The same results were also found in the results of the study by Reddy et al (2020)…”

“…In addition, research on market overreaction on stock exchanges classified as emerging markets was also conducted by Reddy et al (2020) Han et al (2015) suggests that market overreaction is more often observed in the stock market, classified as an emerging market than in developed markets.…”

Opportunistic timing of management earnings forecasts during the COVID‐19 crisis in China

“…Further, pandemic‐related stock price declines are most severe during the sample period (Davis et al ., 2021). It is especially the case in China because investor sentiment and overreaction are more pronounced in emerging markets than in developed markets (e.g., Wang et al ., 2004; Reddy et al ., 2021), and pandemic‐related policies in China are particularly strict (e.g., Yan, 2020; Davis et al ., 2021). Consequently, the COVID‐19‐induced capital‐market pressure is more significant in China.…”

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“…The overreaction hypothesis implies that the investors overreact due to the new knowledge initially, causing the prices to deviate from their fundamental values and then correct by taking the prices back to the fundamental values (Reddy, Qamar, Mirza, & Shi, 2020). However, the name "price bubble" conjures a mental picture of a swelling soap bubble, which is doomed to burst suddenly and irreparably (Shiller, 2015b).…”