There are different ways of thinking about whether or not the stock market overreacts. Economist John Maynard Keynes' believed that the stock market acted something like a casino, with investors guided by the short-term desire to make money and likely to overreact to market conditions. The Efficient Market Hypothesis (EMH), on the other hand, postulates that investors base their decisions on rational calculations and long-term thinking and do not tend to overreact. The reality may be that both theories are partially correct.
For the stock market to react rationally, and never overreact, investors must always base their decisions on future investment yields and prices. Keynes argued that, since it is impossible for investors to know the future, some investors must base their decisions on what other investors are doing. This creates a situation where the stock market is subject to waves of overreaction -- where people are basing their decisions to buy or sell on whether other people are buying or selling, and not on rational considerations.
There is some evidence that the market can overreact to company earnings announcements. A 1985 study by Werner De Bondt and Richard Thaler demonstrated that stock prices sometimes rise or fall abnormally following earnings reports. Other researchers have added that an overreaction to earnings reports can build over time, so that stock prices appear to react normally to an earnings announcement at first, and then become more irrational over time. For example, prices may go up a small amount in response to a report of better-than-expected earnings, and then continue to go up over time in an overreaction, to the point where the stock becomes greatly overvalued.
Standard & Poor's Effect
A 1986 study by L. Harris and E. Gurel found that share prices tended to increase when a stock was included on the Standard & Poor 500 index -- a list of 500 of the most widely held common stocks. Being listed on the S&P; does not represent any new information about a company's profits or way of doing business, so inclusion on the S&P; should not affect stock prices. The fact that it does points to the market overreacting to the news that a stock is being included on the S&P.;
Stock prices sometimes rise and fall based on factors other than the financial performance of a company. For example, there is some evidence that sunny weather correlates with rises in the stock market, and that the market tends to rise on the day just before a public holiday. Stock prices also tend to fall when there is bad news, even if the news does not directly affect business. These types of anomalies in stock market prices are irrational and may suggest that the market is over-reacting to non-financial information and events.
- "Journal of Finance"; Does the Stock Market Overreact?; Werner De Bondt, et al.; 1985
- Eric Falkenstein; Andrew Shleiffer's Inefficient Markets; 2001
- ETH Zurich Chair of Entrepreneurial Risks; The Efficient Market Hypothesis on Trial: A Survey; Philip S. Russel and Violet M. Torbey
- "Journal of Finance 41"; Price and Volume Effects Associated with Changes in the S&P; 500 List: New Evidence for the Existence of Price Pressures; L. Harris, et al.; 1986
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