The Timing Of Equity Mean Reversion In Relation To The Global Economic Cycle

Abstract

Investor overreaction results in the systematic overshooting of stock prices and their subsequent mean reversion. International studies on the overreaction hypothesis generally find that the mean reversion of stock returns take place after a consistent winning or losing trek for over 36 months. We construct monthly-rebalanced prior 36-month winner and loser portfolios from global equities and examine their characteristics over the period from 1999 to 2009. Using the residual returns from the capital asset pricing model (CAPM) and the 3-factor model of Fama and French (1993) as proxies for monthly abnormal returns, it is found that the loser portfolio accumulates abnormal returns mainly during turbulent times while the winner portfolio accumulates abnormal returns mainly during the upswing of the economic cycle. The resilient nature of the loser portfolio in the downswing of the economic cycle suggests that investments in past long-term losers could be regarded as a safe haven during financial market turmoil. In line with the prior study results conducted on South African stocks, the abnormal returns between the winner and loser portfolios are negatively correlated and the winner-loser spreads are found to be cyclical in relation to the economic cycle for global equities as investor sentiments and future prospects change.