Market overreaction and underreaction: tests of the directional and magnitude effects

Applied Economics, Volume 23, Issue 18, pp1469-1482

We investigate whether the US equity market exhibits underreaction or overreaction. More specifically, we study the directional and magnitude effects associated with abnormal market reaction. The directional effect is the phenomenon that an extreme price movement will be followed by a price movement in the opposite (overreaction hypothesis) or same (underreaction hypothesis) direction. The magnitude effect is the phenomenon that the more extreme the initial price movement is, the greater the subsequent adjustment will be. In this article, we study both effects by considering extreme, medium and mild winner–loser portfolios. The directional effect is assessed by the profits generated by these portfolios, and the magnitude effect is assessed by comparing the difference in profits between these portfolios. Three tests are developed and applied to test the magnitude effect. Empirically we find support for both of these effects for extreme, medium and mild winner–loser portfolios.

Keywords: overreaction hypothesis, underreaction hypothesis, momentum strategy, contrarian strategy, directional effect, magnitude effect, winner portfolio, loser portfolio