Does long-term disequilibrium in stock price predict future returns?
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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.
KeywordsStock returns Cointegration Market efficiency
JEL ClassificationG12 G14
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.
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