Overreaction diamonds: precursors and aftershocks for significant price changes

Abstract

Overreactions and other behavioral effects in stock prices can best be examined by adjusting for the changes in fundamentals. We perform this by subtracting the relative price changes in the net asset value (NAV) from that of market price (MP) daily for 134 406 data points of closed-end funds trading in US markets. We examine the days before and after a significant rise or fall in price deviation and MP return and find evidence of overreaction in the days after the change. Prior to a spike in deviation we find a gradual two- or three-day decline (and analogously in the other direction). Overall, there is a characteristic diamond pattern, revealing a symmetry in deviations before and after the significant change. Much of the statistical significance and the patterns disappear when the subtraction of NAV return is eliminated, suggesting that the frequent changes in fundamentals mask behavioral effects. A second study subdivides the data depending on whether the NAV or market price is responsible for the spike in the relative difference. In a majority of spikes, it is the change in market price rather than NAV that is dominant. Among those spikes for which there is little or no change in NAV, the results are similar to the overall study. Furthermore, the upward spikes are preceded by one or two days of declining market price while NAV rises slightly or is relatively unchanged. This suggests that a cause of the spike may be due to over-positioning of traders in the opposite direction in anticipation.

Keywords:

• Overreaction
• Price deviation
• Diamond pattern
• Over-positioning
• Market dynamics
• Financial markets
• Behavioral finance
• Closed-end funds

Acknowledgements

The authors are grateful for the support of LGT Capital Management and the International Foundation for Research in Experimental Economics (IFREE). The suggestions of two anonymous referees are also appreciated. The authors may have long or short positions on securities discussed in the paper.

Notes

†Value-based managers often say that some stocks (particularly those that are not in the limelight) are chronically undervalued. However, since there is no unique calculation to assess the value of a typical industrial corporation, the studies that can be done (e.g. using price-to-earnings ratios) are not as precise or convincing as the studies of closed-end funds.