Advertisement

Review of Quantitative Finance and Accounting

, Volume 41, Issue 4, pp 753–767 | Cite as

Does long-term disequilibrium in stock price predict future returns?

  • Jungshik Hur
  • Vivek Singh
Original Research
  • 279 Downloads

Abstract

We propose a trading strategy based on error correction term (ECT), the residuals from the cointegration relation between the levels of security and the market portfolio. We find that buying stocks in the top 10 % ECT and selling stocks in the bottom 10 % ECT generates 1.09 % a month for 6-month holding period over 1965–2005. The monthly return increases to 1.57 % when the above trading strategy is applied to stocks with insignificant cointegration with the market portfolio. This profit is robust to three and four factor models. Moreover, this profit is neither driven by small and illiquid stocks nor is the result of any inherent positive serial correlation.

Keywords

Stock returns Cointegration Market efficiency 

JEL Classification

G12 G14 

Notes

Acknowledgments

We are grateful for the valuable suggestions from the Editor, C F Lee and an anonymous referee that have significantly improved the quality of the paper. We also thank discussants and participants of Financial Management meetings of 2011, Eastern Finance Association meetings of 2011, and Midwest Finance Association meetings of 2011 for their helpful comments.

References

  1. Alexander C (1999) Optimal hedging using cointegration. Philos Trans R Soc Ser A357:2039–2058CrossRefGoogle Scholar
  2. Alexander C, Dimitriu A (2005a) Indexing and statistical arbitrage: tracking error or cointegration? J Portfolio Manag 31(2):50–63CrossRefGoogle Scholar
  3. Alexander C, Dimitriu A (2005b) Indexing, cointegration and equity market regimes. Int J Financ Econ 8(2):213–231CrossRefGoogle Scholar
  4. Banerjee A, Dolado JJ, Galbraith JW, Hendry DF (1993) Cointegration, error correction and the econometric analysis of nonstationary data. Oxford University Press, OxfordCrossRefGoogle Scholar
  5. Bansal R, Yaron A (2004) Risks for the long run: a potential resolution of asset pricing puzzles. J Financ 59(4):1481–1509CrossRefGoogle Scholar
  6. Bansal R, Dittmar RF, Lundblad CT (2005) Consumption, dividends, and the cross-section of equity returns. J Financ 60(4):1639–1672CrossRefGoogle Scholar
  7. Bansal R, Gallant AR, Tauchen G (2007) Rational pessimism, rational exuberance, and asset pricing models. Rev Econ Stud 74(4):1005–1033CrossRefGoogle Scholar
  8. Bansal R, Dittmar RF, Kiku D (2009) Cointegration and consumption risks in asset returns. Rev Financ Stud 22(3):1343–1375CrossRefGoogle Scholar
  9. Campbell JY, Mankiw NG (1987) Are output fluctuations transitory? Q J Econ 102(4):857–880CrossRefGoogle Scholar
  10. Chiu IM (2008) An Empirical Study on the Long-Run Determinants of Exchange Rate. Rev Pac Basin Financ Mark Pol 11(3):389–409CrossRefGoogle Scholar
  11. Cochrane JH (1988) How big is the random walk in GNP? J Polit Econ 96(5):893–920CrossRefGoogle Scholar
  12. DeBondt W, Thaler R (1985) Does the stock market overreact? J Financ 40(3):793–805CrossRefGoogle Scholar
  13. DeBondt W, Thaler R (1987) Further evidence on investor overreaction and stock market seasonality. J Financ 42(3):557–581CrossRefGoogle Scholar
  14. Dunis C, Ho R (2005) Cointegration portfolios of European equities for index tracking and market neutral strategies. J Asset Manag 6(1):33–52CrossRefGoogle Scholar
  15. Fama EF (1998) Market efficiency, long-term returns, and behavioral finance. J Financ Econ 49(3):283–306CrossRefGoogle Scholar
  16. Fama EF, MacBeth J (1973) Risk, return, and equilibrium: empirical tests. J Polit Econ 81(3):607–636CrossRefGoogle Scholar
  17. Ghosh A (1996) Cross-hedging foreign currency risk: empirical evidence from an error correction model. Rev Quant Financ Acc 6(3):223–231CrossRefGoogle Scholar
  18. Granger CWJ (1981) Some properties of time series data and their use in econometric model specification. J Econom 16(1):121–130CrossRefGoogle Scholar
  19. Greene WH (2008) Econometric analysis. Prentice Hall, Upper Saddle RiverGoogle Scholar
  20. Grundy BF, Martin SR (2001) Understanding the nature of the risks and the source of the rewards to momentum investing. Rev Financ Stud 14(1):29–79CrossRefGoogle Scholar
  21. Hansen LP, Heaton JC, Li N (2006) Consumption strikes back? Measuring long-run risk. Working paper, University of ChicagoGoogle Scholar
  22. Jegadeesh N, Titman S (1993) Returns to buying winners and selling losers: implications for stock market efficiency. J Financ 48(1):65–91CrossRefGoogle Scholar
  23. Kremers JJ, Ericsson NR, Dolado JJ (1992) The power of cointegration tests. Oxf Bull Econ Stat 54(3):325–348CrossRefGoogle Scholar
  24. Lin CC, Chen CY, Hwang DY (2003) An application of threshold cointegration to Taiwan stock index futures and spot markets. Rev Pac Basin Financ Mark Pol 6(3):291–304CrossRefGoogle Scholar
  25. Maddala GS, Kim I (2003) Unit roots, cointegration and structural change. Cambridge University Press, CambridgeGoogle Scholar
  26. Mitchell ML, Stafford E (2000) Managerial decisions and long-term stock price performance. J Bus 73(3):287–329CrossRefGoogle Scholar
  27. Nelson CR, Plosser CI (1982) Trends and random walks in macroeconomics time series. J Monet Econ 10(2):139–162CrossRefGoogle Scholar
  28. Newey WK, West KD (1987) A simple, positive semi-definite, heteroskedasticity and autocorrelation consistent covariance matrix. Econometrica 55(3):703–708CrossRefGoogle Scholar
  29. Ogaki M, Park JY (1990) A cointegration approach to estimating preference parameters. University of Rochester, MimeoGoogle Scholar
  30. Shrestha K, Welch RL (2001) Relationship between expected treasury bill and eurodollar interest rates: a fractional cointegration analysis. Rev Quant Financ Acc 16(1):65–80CrossRefGoogle Scholar
  31. Stock JH, Watson MW (1988) Testing for common trends. J Am Stat Assoc 83(404):1097–1107CrossRefGoogle Scholar
  32. Zivot E (1994) Single equation conditional error correction model based tests for cointegration. Discussion paper 94-12, Department of Economics, University of Washington SeattleGoogle Scholar

Copyright information

© Springer Science+Business Media New York 2012

Authors and Affiliations

  1. 1.Department of Economics and FinanceLouisiana Tech UniversityRustonUSA
  2. 2.Department of Accounting and FinanceUniversity of MichiganDearbornUSA

Personalised recommendations