From the April 2014 issue of Investment Advisor • Subscribe!

Overreaction Moves Markets, but Cooler Heads Can Profit

Statistically, humans are bound to act irrationally

It is no secret that humans are prone to overreaction. Take, for example, former Indiana University basketball coach Bob Knight throwing a chair in front of a player shooting free throws, or NFL coach Jim Mora ranting about the irrelevance of the playoffs after his Indianapolis Colts turned it over five times against the San Francisco 49ers, or a nation of Chicago Cubs fans forcing one of their own to contemplate joining a witness protection program after disrupting a foul ball. These are great examples of how humans can let their emotions blow a situation out of proportion.

Human overreaction is not limited to sports and is often a driver of volatility in financial markets. The abundance of financial data coupled with extremely low transaction costs has made it easy for investors to indulge in knee-jerk reactions to market events over the last decade. A negative news report can cause investors to heedlessly dump a stock one day only to see it chased back up to new highs the next day. For example, on Jan. 13, the S&P 500 (SPX) fell 1.26% as investors reacted to a Federal Reserve official hinting at additional tapering. However, the next day the index rebounded 1.08% on no material news. This whip-saw volatility can make life difficult for investors, but is a source of consistent opportunity for short-term countertrend traders.

The efficient market hypothesis has lulled people into believing that financial markets are completely efficient and that investors do not overreact to events in a predictable and exploitable manner. The statistics tell a different story. From the beginning of 2000 to the end of 2013, the S&P 500 was up 53.21% of its trading days. However, it was up 61.94% of trading days immediately following a day where the index was down by at least twice the standard deviation of its returns over the previous 20 days. Statistics suggest that there is only a 2.14% chance of randomly observing an up-day percentage as high as 61.94% over a 14-year period. Thus, these two-deviation-down days are likely instances of short-term overreactions that are quickly corrected by the market, and they present high-accuracy trading opportunities.

Percentage of Up Days Versus Percentage of Post-Overreaction Up Days

This short-term overreaction phenomenon has its roots in human nature, so one would expect it to be evident in foreign markets as well. Table 1 illustrates the percentage of up days in the Euro Stoxx 50 Index (SX5E) and the Nikkei 225 Index (NKY) immediately following a two-deviation-down day. From 2000 to 2013, the percentage of up days immediately following these two-deviation-down days was significantly higher than the overall percentage of total up days for both indexes. Clearly human overreaction is not limited to the U.S. stock market. Investors across the globe have the same tendency to respond emotionally to market events, creating high-accuracy trading opportunities in domestic and foreign markets.

Overreacting is a fundamental element of human nature. As long as humans are given an outlet to rapidly express their emotions (sell a stock out of fear or throw a chair out of anger), they will use this outlet to diffuse their anxiety and frustration. Fortunately, overreactions create predictable and exploitable opportunities in financial markets across the globe for those investors willing to suppress their inner Richard Sherman.

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