288 E.F.FamafJournal of Financial Economics 49 (1998)283-306 their results suffice to illustrate an important point:Inferences about market efficiency can be sensitive to the assumed model for expected returns. Finally,but most important,a roughly even split between overreaction and underreaction would not be much support for market efficiency if the long-term return anomalies are so large they cannot possibly be attributed to chance. Section 5 argues,however,that even viewed individually,most anomalies are shaky.They tend to disappear when reasonable alternative approaches are used to measure them. 3.Behavioral models of underreaction and overreaction Before examining individual long-term return studies,I first consider two behavioral models,recently proposed by Barberis,Shleifer,and Vishny(BSV 1998)and Daniel,Hirshleifer,and Subramanyam(DHS 1997),to explain how the judgment biases of investors can produce overreaction to some events and underreaction to others. The BSV model is motivated by evidence from cognitive psychology of two judgment biases.(i)The representativeness bias of Kahneman and Tversky (1982):People give too much weight to recent patterns in the data and too little to the properties of the population that generates the data.(ii)Conservatism, attributed to Edwards(1968):The slow updating of models in the face of new evidence. In the model of stock prices proposed by BSV to capture the two judgment biases,earnings are a random walk,but investors falsely perceive that there are two earnings regimes.In regime A,which investors assume is more likely, earnings are mean-reverting.When investors decide regime A holds,a stock's price under-reacts to a change in earnings because investors mistakenly think the change is likely to be temporary.When this expectation is not confirmed by later earnings,stock prices show a delayed response to earlier earnings.In regime B,which investors think is less likely,a run of earnings changes of the same sign leads investors to perceive that a firm's earnings are trending.Once investors are convinced that the trending regime B holds,they incorrectly extrapolate the trend and the stock price over-reacts.Because earnings are a random walk,the overreaction is exposed by future earnings,leading to reversal of long-term returns. Regime A in the BSV model is motivated by the evidence of short-term momentum in stock returns (Jegadeesh and Titman,1993)and the evidence of delayed short-term responses of stock prices to earnings announcements(Ball and Brown,1968;Bernard and Thomas,1990).Regime B is meant to explain the long-term return reversals of DeBondt and Thaler(1985)and the returns to the contrarian investment strategies of Lakonishok et al.(1994).How does the model do on other anomalies?
their results suffice to illustrate an important point: Inferences about market efficiency can be sensitive to the assumed model for expected returns. Finally, but most important, a roughly even split between overreaction and underreaction would not be much support for market efficiency if the long-term return anomalies are so large they cannot possibly be attributed to chance. Section 5 argues, however, that even viewed individually, most anomalies are shaky. They tend to disappear when reasonable alternative approaches are used to measure them. 3. Behavioral models of underreaction and overreaction Before examining individual long-term return studies, I first consider two behavioral models, recently proposed by Barberis, Shleifer, and Vishny (BSV 1998) and Daniel, Hirshleifer, and Subramanyam (DHS 1997), to explain how the judgment biases of investors can produce overreaction to some events and underreaction to others. The BSV model is motivated by evidence from cognitive psychology of two judgment biases. (i) The representativeness bias of Kahneman and Tversky (1982): People give too much weight to recent patterns in the data and too little to the properties of the population that generates the data. (ii) Conservatism, attributed to Edwards (1968): The slow updating of models in the face of new evidence. In the model of stock prices proposed by BSV to capture the two judgment biases, earnings are a random walk, but investors falsely perceive that there are two earnings regimes. In regime A, which investors assume is more likely, earnings are mean-reverting. When investors decide regime A holds, a stock’s price under-reacts to a change in earnings because investors mistakenly think the change is likely to be temporary. When this expectation is not confirmed by later earnings, stock prices show a delayed response to earlier earnings. In regime B, which investors think is less likely, a run of earnings changes of the same sign leads investors to perceive that a firm’s earnings are trending. Once investors are convinced that the trending regime B holds, they incorrectly extrapolate the trend and the stock price over-reacts. Because earnings are a random walk, the overreaction is exposed by future earnings, leading to reversal of long-term returns. Regime A in the BSV model is motivated by the evidence of short-term momentum in stock returns (Jegadeesh and Titman, 1993) and the evidence of delayed short-term responses of stock prices to earnings announcements (Ball and Brown, 1968; Bernard and Thomas, 1990). Regime B is meant to explain the long-term return reversals of DeBondt and Thaler (1985) and the returns to the contrarian investment strategies of Lakonishok et al. (1994). How does the model do on other anomalies? 288 E.F. Fama/Journal of Financial Economics 49 (1998) 283—306
E.F.FamafJournal of Financial Economics 49 (1998)283-306 289 The prediction of regime B is reversal of long-term abnormal returns.Specifi- cally,persistent long-term pre-event returns are evidence of market overreaction which should eventually be corrected in post-event returns.In addition to DeBondt and Thaler(1985)and Lakonishok et al.(1994),other events consistent with this prediction are seasoned equity offerings(Loughran and Ritter,1995; Mitchell and Stafford,1997),new exchange listings(Dharan and Ikenberry, 1995),and returns to acquiring firms in mergers(Asquith,1983).All these events are characterized by positive long-term abnormal returns before the event and negative abnormal returns thereafter. But long-term return reversal is not the norm.Events characterized by long-term post-event abnormal returns of the same sign as long-term pre-event returns include dividend initiations and omissions(Michaely et al.,1995),stock splits(Ikenberry et al,1996;Desai and Jain,1997),proxy contests(Ikenberry and Lakonishok,1993),and spinoffs (Miles and Rosenfeld,1983;Cusatis et al. 1993. In short,and not surprisingly,the BSV model does well on the anomalies it was designed to explain.But its prediction of long-term return reversal does not capture the range of long-term results observed in the literature.On the whole, the long-term return literature seems more consistent with the market efficiency prediction that long-term return continuation and long-term return reversal are equally likely chance results. The DHS model has different behavioral foundations than the BSV model.In DHS there are informed and uninformed investors.The uninformed are not subject to judgment biases.But stock prices are determined by the informed investors,and they are subject to two biases,overconfidence and biased self- attribution.Overconfidence leads them to exaggerate the precision of their private signals about a stock's value.Biased self-attribution causes them to downweight public signals about value,especially when the public signals contradict their private signals.Overreaction to private information and under- reaction to public information tend to produce short-term continuation of stock returns but long-term reversals as public information eventually overwhelms the behavioral biases.Thus,though based on different behavioral premises,the DHS predictions are close to those of BSV,and the DHS model shares the empirical successes and failures of the BSV model.This last comment also applies to Hong and Stein(1997). DHS make a special prediction about what they call selective events.These are events that occur to take advantage of the mispricing of a firm's stock.For example,managers announce a new stock issue when a firm's stock price is too high,or they repurchase shares when the stock price is too low.This public signal produces an immediate price reaction that absorbs some of the mispric- ing.But in the DHS model,the announcement period price response is incom- plete because informed investors overweight their prior beliefs about the stock's value.(The conservatism bias of the BSV model would produce a similar result.)
The prediction of regime B is reversal of long-term abnormal returns. Specifi- cally, persistent long-term pre-event returns are evidence of market overreaction which should eventually be corrected in post-event returns. In addition to DeBondt and Thaler (1985) and Lakonishok et al. (1994), other events consistent with this prediction are seasoned equity offerings (Loughran and Ritter, 1995; Mitchell and Stafford, 1997), new exchange listings (Dharan and Ikenberry, 1995), and returns to acquiring firms in mergers (Asquith, 1983). All these events are characterized by positive long-term abnormal returns before the event and negative abnormal returns thereafter. But long-term return reversal is not the norm. Events characterized by long-term post-event abnormal returns of the same sign as long-term pre-event returns include dividend initiations and omissions (Michaely et al., 1995), stock splits (Ikenberry et al., 1996; Desai and Jain, 1997), proxy contests (Ikenberry and Lakonishok, 1993), and spinoffs (Miles and Rosenfeld, 1983; Cusatis et al., 1993). In short, and not surprisingly, the BSV model does well on the anomalies it was designed to explain. But its prediction of long-term return reversal does not capture the range of long-term results observed in the literature. On the whole, the long-term return literature seems more consistent with the market efficiency prediction that long-term return continuation and long-term return reversal are equally likely chance results. The DHS model has different behavioral foundations than the BSV model. In DHS there are informed and uninformed investors. The uninformed are not subject to judgment biases. But stock prices are determined by the informed investors, and they are subject to two biases, overconfidence and biased selfattribution. Overconfidence leads them to exaggerate the precision of their private signals about a stock’s value. Biased self-attribution causes them to downweight public signals about value, especially when the public signals contradict their private signals. Overreaction to private information and underreaction to public information tend to produce short-term continuation of stock returns but long-term reversals as public information eventually overwhelms the behavioral biases. Thus, though based on different behavioral premises, the DHS predictions are close to those of BSV, and the DHS model shares the empirical successes and failures of the BSV model. This last comment also applies to Hong and Stein (1997). DHS make a special prediction about what they call selective events. These are events that occur to take advantage of the mispricing of a firm’s stock. For example, managers announce a new stock issue when a firm’s stock price is too high, or they repurchase shares when the stock price is too low. This public signal produces an immediate price reaction that absorbs some of the mispricing. But in the DHS model, the announcement period price response is incomplete because informed investors overweight their prior beliefs about the stock’s value. (The conservatism bias of the BSV model would produce a similar result.) E.F. Fama/Journal of Financial Economics 49 (1998) 283—306 289
290 E.F.FamafJournal of Financial Economics 49 (1998)283-306 Eventually,the mispricing is fully absorbed as further public information con- firms the information implied by the event announcement.The general predic- tion for selective events is thus momentum;stock returns after an event an- nouncement will tend to have the same sign as the announcement period return. Does the DHS prediction about selective events stand up to the data?Table 1 summarizes the signs of short-term announcement returns and long-term Table 1 Signs of long-term pre-event,announcement,and long-term post-event returns for various long- term return studies Event Long-term Announcement Long-term pre-event return post-event return return Initial public offerings (IPOs) Not (Ibbotson,1975;Loughran and Ritter,1995) available Seasoned equity offerings (Loughran and Ritter,1995) Mergers(acquiring firm) (Asquith,1983; Agrawal et al.,1992) Dividend initiations (Michaely et al,1995) Dividend omissions (Michaely et al,1995) Earnings announcements Not (Ball and Brown,1968;Bernard available and Thomas,1990) New exchange listings (Dharan and Ikenberry,1995) Share repurchases(open market) (Ikenberry et al,1995;Mitchell and Stafford,1997) Share repurchases (tenders) (Lakonishok and Vermaelen,1990; Mitchell and Stafford,1997) Proxy fights -(or0) (Ikenberry and Lakonishok,1993) Stock splits (Dharan and Ikenberry,1995;Ikenberry etal,1996) Spinoffs +(or0) (Miles and Rosenfeld,1983;Cusatis etal,1993)
Table 1 Signs of long-term pre-event, announcement, and long-term post-event returns for various longterm return studies Event Long-term pre-event return Announcement return Long-term post-event return Initial public offerings (IPOs) (Ibbotson, 1975; Loughran and Ritter, 1995) Not available # ! Seasoned equity offerings (Loughran and Ritter, 1995) #! ! Mergers (acquiring firm) (Asquith, 1983; Agrawal et al., 1992) # 0 ! Dividend initiations (Michaely et al., 1995) ## # Dividend omissions (Michaely et al., 1995) !! ! Earnings announcements (Ball and Brown, 1968; Bernard and Thomas, 1990) Not available # # New exchange listings (Dharan and Ikenberry, 1995) ## ! Share repurchases (open market) (Ikenberry et al., 1995; Mitchell and Stafford, 1997) 0 # # Share repurchases (tenders) (Lakonishok and Vermaelen, 1990; Mitchell and Stafford, 1997) 0 # # Proxy fights (Ikenberry and Lakonishok, 1993) !# ! (or 0) Stock splits (Dharan and Ikenberry, 1995; Ikenberry et al., 1996) ## # Spinoffs (Miles and Rosenfeld, 1983; Cusatis et al., 1993) ## # (or 0) Eventually, the mispricing is fully absorbed as further public information con- firms the information implied by the event announcement. The general prediction for selective events is thus momentum; stock returns after an event announcement will tend to have the same sign as the announcement period return. Does the DHS prediction about selective events stand up to the data? Table 1 summarizes the signs of short-term announcement returns and long-term 290 E.F. Fama/Journal of Financial Economics 49 (1998) 283—306