The short-term return reversal in stocks is an old asset pricing anomaly. It is well known that stock return performance over a short period, said daily or weekly returns, do not necessarily reflect the fundamental return components such as risk premium, future cash flow, and expected discount rate (the health conditions of the firm). In fact, the short-term stock prices often reflect investor behavioral biases such as overreaction to information, loss-aversion, and other cognitive errors as well as emotional bias. For example, fire sales are more likely than fire purchase. Also, in many cases, the recent losing stocks may experience temporarily financial distress, and constrained investors are forced to sell which causes a significant price concession. The later price recovery thus reflects compensation for liquidity provision. This liquidity provision is an indispensable source of the short-term reversal profits.
Although most of the academic literature shows that the profits from short-term reversal strategies may disappear once transaction costs are taken into account, my research found that the impact of trading costs on profitability is mainly contributable from the illiquidity of small-cap stocks. Thus, by limiting the investment population to the largest, most liquid companies, such as S&P500, the investment products based on the short-term reversal strategy can be profitable.
It is important to note that many short-term losing stocks may not be caused by just the behavioral biases. The losses could be attributable to the deterioration of the firm’s structural stability of return (or the health of the firm). Then, these losses are unlikely to be recovered. Therefore, the question is how to distinguish between healthy and unhealthy losers at least in the short-term? Instead of using traditional fundamental analysis or asset pricing modeling approach, We develop a short-term performance index called Chow Ratio that simultaneously measures the return-stability (the health) and potential return-reversal. Specifically, lower the Chow Ratio score, higher the possibility of short-term reversal. We apply the Chow Ratio approach to the S&P500 stocks and form the Vesper US Large Cap Short-Term Reversal Index (UTRNX) by selecting the 25 most potentially reversal stocks on a weekly basis. In short, UTRNX is indeed an enhanced index of the S&P500 in that it is highly correlated, more stable and outperforms the benchmark over the time.