DeBondt and Thaler (1985) found that stock prices tend to show a reversal after periods of extreme movement. This suggests that investors overreact to information and the subsequent reversals are a correction of the initial over-reaction. Presence of over- and under-reaction in financial markets contradicts the basic premise of market efficiency, and implies that abnormal returns can be earned in financial markets.
We explore the presence of over- or under-reaction in the top 10 stock markets in the world as per market capitalisation. A reversal in prices post an extreme movement suggests the presence of over-reaction bias while a continuation in trend denotes presence of under-reaction. Absence of significant abnormal returns after price shocks implies that markets are informationally efficient.
To our knowledge, there is no study on the comparative analysis of over/under reaction in 10 major stock markets, namely USA, UK, Japan, China, Hong Kong, Canada, Germany, India, Switzerland and Australia. Also, this study uses intra-day price data which enables us to better analyse market behaviour in the short term as it is possible that the corrections in the market may last only for a few minutes or for hours.
To summarise the results, we find evidence for the presence of over- and/or under- reaction in all but two of the stock markets (Japan and the UK). In some cases, the market corrects the bias within the first few hours of post event trading (China), while in some other cases the correction lasts even up to six days (Switzerland and India). In fact, the behaviour of most markets is different in case of positive and negative shocks. So, the market’s reaction to a price event is conditional upon the direction of the shock suggesting that investors react differently to negative and positive information.
