Winners, losers and market regimes

Abstract

This thesis examines the effect of market states on momentum profits and long-run reversals. I use a regime-switching model to classify the market into up states with positive mean returns and down states with negative mean returns. I then examine the effects of ranking period and post-ranking period market states on short-run momentum and long-run reversals in the context of recent behavioral finance theories (Daniel, Hirschleifer and Subrahmanyam 1998 and Hong and Stein 1999) which are based on investorsa?? overreactions to news. The empirical results about momentum and long-run reversals are partially consistent with the predictions of the behavioral models. Further, I extend the behavioral models to predict the behaviors of winners and losers separately. Consistent with the predictions, I find that past winners have higher returns following up markets than following down markets in the short run (1-12 months). However, past losers actually have higher return following down markets than up market in the short run, which is inconsistent with the predictions. Moreover, I find that in the long run the reversals are actually independent of prior market states. The overall picture is thus more complicated compared to what we can infer from the existing behavioral theories.