Long-Term Return Reversals: Overreaction or Taxes
Thomas J. George tom-george@uh.edu C.T. Bauer College of Business University of Houston Houston, TX 77204 and
Chuan-Yang Hwang cyhwang@ntu.edu.sg Division of Banking and Finance Nanyang Business School Nanyang Technological University Singapore 639798 and Department of Finance School of Business and Management Hong Kong University of Science and Technology Clear Water Bay, Hong Kong
June 2006
Acknowledgements: We are grateful to Jonathan Berk, Mark Grinblatt, Tom Rourke, Robert Stambaugh (the editor), an anonymous referee, and seminar participants at Hong Kong University of Science and Technology for helpful discussions and comments. Harry Leung provided excellent research assistance. George acknowledges financial support of the C.T. Bauer Professorship. Hwang acknowledges RGC grant HKUST6011/00H.
Long-Term Return Reversals: Overreaction or Taxes
Abstract
Long-term reversals in US stock returns are better explained by the rational reactions of investors to locked-in capital gains than irrational overreaction to news. Predictors of returns based on the overreaction hypothesis have no power, while those that measure the extent of locked-in capital gains do have predictive power and completely subsume past returns measures that traditionally have been used to predict long-term returns. We also examine data from Hong Kong, where investment income is not taxed. Reversals are non-existent in Hong Kong, and returns are not forecastable either by traditional measures, or by measures based on the capital gains lock-in hypothesis that successfully predict returns in US data.
Key words: return reversal, overreaction, capital gains lock-in.
Introduction
Short to medium term momentum in security returns was first documented by Jegadeesh and Titman (1993). They show that winner stocks over the past six months outperform losers by 1% per month during the next six to twelve months. DeBondt and Thaler (1985) show that loser stocks in the past three to five years outperform winners by 25% over the next three years. These findings of short-term momentum and long-term reversals are the empirical cornerstones of the study of behavioral finance. Prominent theoretical models in this area such as Barberis, Shleifer and Vishny (1998), Daniel, Hirshleifer and Subrahmanyam (1998) and Hong and Stein (1999) all treat short-term momentum and long-term reversals as inseparable phenomena. In Barberis, Shleifer and Vishny and Hong and Stein, momentum occurs because traders are slow to revise their priors when new information arrives. Long-term reversals occur because when traders finally do adjust, they overreact. In Daniel, Hirshleifer and Subrahmanyam, momentum occurs because traders overreact to prior information when new information confirms it. Long-term reversals occur as the overreaction is corrected in the long run. In all three models, short-term momentum and long-term reversals are sequential components of the process by which the market absorbs a news item. This view is supported by evidence that return momentum documented in Jegadeesh and Titman (1993) reverses in the long run (see Jegadeesh and Titman (2001)).

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