Stock Price Overreaction Effect: Evidence on Nasdaq Stocks, The

Quarterly Journal of Finance and Accounting, Summer 2005 by Ma, Yulong, Tang, Alex P, Hasan, Tanweer

We empirically investigate the market overreaction effect of the stocks with the largest daily percentage increases or decreases in price reported in The Wall Street Journal between January 1996 and December 1997. We select 852 stocks for the NYSE and Nasdaq samples of gainers and losers. We find strong evidence of stock price overreaction effects for both the Nasdaq gainers and losers samples but no such evidence for either the NYSE samples. The reversal of stock returns occurs within a two-day post-event period. Regression analysis shows that the stock price reversal is inversely related to the price gains or losses controlling for the size of Nasdaq firms.

Introduction

The stock market overreaction hypothesis states that a stock price usually reverses itself after the stock experiences a sharp increase or decrease in price. If this hypothesis holds, then profitable investment strategies can be constructed to take advantage of the overreaction effect. Therefore, a further understanding of the overreaction effect has important implications not only for academics and practitioners, but also for the investing public. In this paper, we use a two-calendar-year data set from The Wall Street Journal to empirically investigate the stock price overreaction effect on stocks that have experienced the largest percentage price increases or decreases on any trading day from January 1996 to December 1997.

The issue of stock market overreaction is not a new one. Among the early well-known studies are those by Beaver and Landsman (1981) and DeBondt and Thaler (1985). The new developments in market environments and the inconclusiveness of the previous research on this issue make this area important. The advent of the internet as a mass communication tool and the advance in communication technology means that information can now be more quickly and more cheaply disseminated than ever before. It may be an empirical issue whether these developments will help increase or decrease the overreaction effect. Further, stock market investments are no longer confined to financial professionals and elite investors. More individuals have begun to participate actively in the stock markets; and more retirement money has been channeled to the stock markets through institution-sponsored pension funds. Therefore, a better understanding of the market overreaction effect could help financial professionals and the investing public to formulate their investment strategies.

Using the stocks with the daily largest percentage change in price reported in The Wall Street Journal, we find that even though the two-day abnormal returns are about 22 percent for the NYSE gainers and -18 percent for the NYSE losers, there is no evidence of any significant overreaction effect for either the NYSE gainers or the losers. On the other hand, we find significant abnormal returns over two consecutive days right after the event day for the Nasdaq gainer and losers. We observe a stronger overreaction effect for the loser stocks. The two-day event-period abnormal returns for Nasdaq stocks are 38 percent for the gainers and -35 percent for the losers. The abnormal returns during the two-day period following the event day are -1.76 percent for the gainers and 4.5 percent for the losers. Both results are significant at the 0.01 level. Further, in our regression analysis we find that both firm size and prior stock performance are statistically significant factors in determining the overreaction effect.

Background and Relevant Literature

Previous studies on stock market overreaction have generated two important implications. First, the existence of the overreaction phenomenon is against the widely accepted market efficiency theory. second, the studies question if investors can establish practical and profitable investment strategies to take advantage of the overreaction effect.

The semi-strong form market efficiency theory states that stock prices quickly reflect all publicly available information, implying that no overreaction effect should exist. Empirical finance literature (e.g., Fama, 1970 and 1991) documents strong evidence in support of the semi-strong market efficiency hypothesis. On the other hand, several studies (e.g., Conrad and Kaul, 1988 and Lo and MacKinley, 1988.) find significant empirical results inconsistent with the efficient market hypothesis. Finance researchers generally consider the latter phenomena as market efficiency anomalies rather than outright rejections of the efficient market hypothesis. For example, French (1980), Gibbons and Hess (1981), Keim and Stambaugh (1984), and Rogalski (1984) find evidence of day-of-the-week and weekend effects on stock returns; Banz (1981) and Reinganum (1983) show the evidence of a size effect on stock returns; and Ariel (1987) shows the January effect.

Among these so-called market efficiency anomalies is the issue of stock market overreaction. Although we examine the issue of overreaction effect, the focus of our paper is investigating the returns behavior of the stocks rather than finding proof or disproof of the efficiency hypothesis. Theoretically, if the stock market overreaction exists, what causes it? The answer may lie in both how well individual investors are informed and in the psychology of the individual decision-making process. The combined effect is that investors tend to overreact to unexpected new information. They are likely to overbid or underbid a firm's stock and then later reverse themselves. Researchers believe that this phenomenon is especially evident for significant and negative events. Prior findings from experimental psychology (e.g., Kahneman and Tversky, 1982) have found that people tend to overreact to unexpected news events. The study of the effect of human behavior on investors' financial decisionmaking is called behavioral finance.