Market prediction tomorrow
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Does academic evidence support these types of predictions, based on recent pricing? In this article, we'll look at four different views of the market and learn more about the associated academic research that supports each view. The conclusions will help you better understand how the market functions, and perhaps eliminate some of your own biases.
"Don't fight the tape." This widely quoted piece of stock market wisdom warns investors not to get in the way of market trends. The assumption is that the best bet about market movements is that they will continue in the same direction. This concept has is roots in behavioral finance. With so many stocks to choose from, why would investors keep their money in a stock that's falling, as opposed to one that's climbing? It's classic fear and greed. (For more insight, see the tutorial.)
Studies have found that mutual fund inflows are positively correlated with market returns. Momentum plays a part in the decision to invest and when more people invest, the market goes up, encouraging even more people to buy. It's a positive feedback loop.
A 1993 study by Narasimhan Jagadeesh and Sheridan Titman, "Returns to Buying Winners and Selling Losers, " suggests that individual stocks have momentum. They found that stocks that have performed well during the past few months, are more likely to continue their outperformance next month. The inverse also applies; stocks that have performed poorly, are more likely to continue their poor performance.
However, this study only looked ahead a single month. Over longer periods, the momentum effect appears to reverse. According to a 1985 study by Werner DeBondt and Richard Thaler, "Does the Stock Market Overreact?" stocks that have performed well in the past three to five years are more likely to underperform the market in the next three to five years and vice versa. This suggests that something else is going on: mean reversion.
Experienced investors who have seen many market ups and downs, often take the view that the market will even out, over time. Historically high market prices often discourage these investors from investing, while historically low prices may represent an opportunity.
The tendency of a variable, such as a stock price, to converge on an average value over time is called mean reversion. The phenomenon has been found in several economic indicators, including exchange rates, gross domestic product (GDP) growth, interest rates and unemployment. Mean reversion may also be responsible for business cycles. (For more insight, check out and .)
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