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Mean Reversion Effect in Country Equity Indexes

DeBondt and Thaler in 1985 have found the presence of the winner-loser reversals in the U.S. stock market. The idea is simple, stocks that have been "losers" in a given ranking period are likely to yield subsequently higher returns than the corresponding "winner" stocks. Since the first study, the winer-loser reversals in the U.S. stocks have been largely studied by the academics and the idea was slightly modified in search of even better performance.

Moreover, the winner-loser reversals were also found by the Richards (1995) in national stock market indices. This paper extends his research and explores it even more, while using data for the return indices of 16 national markets. The finding of the paper, that reversals are strongest around the 3-year horizon during the testing period results in a simply manageable strategy. The results are similar to those of Balvers, Wu and Gilliland in the "Stock Markets and Parametric Contrarian Investment Strategies". They have found a strong evidence of mean reversion in relative stock index prices. Their findings imply a significantly positive speed of reversion with a halflife of three to three and one-half years (similar to results of this paper). Additionally, their result is robust to alternative specifications and data.

The results could be also linked with the work of Spierdijk, Bikker and Van den Hoek - "Mean Reversion in International Stock Markets: An Empirical Analysis of the 20th Century", this paper analyzes mean reversion in international stock markets during the period 1900-2008, using annual data and stock indexes in seventeen developed countries, covering a time span of more than a century. They have documented, the half-lives ranging from a minimum of 2.1 years to a maximum of 23.8 years. Their results also suggest that the speed at which stocks revert to their fundamental value is higher in periods of high economic uncertainty, caused by major economic and political events. Additionaly, although the reversion in stock indices is present and profitable, we can say the same about momentum. Balvers and Wu in the "Momentum and mean reversion across national equity markets" explored this effects jointly. Quoting the authors: "Combination momentum-contrarian strategies, used to select from among 18 developed equity markets at a monthly frequency, outperform both pure momentum and pure contrarian strategies".

Fundamental reason

The paper has explored potential explanations for reversals in the relative performance of national stock markets over periods of several years. However, there are some factors that make it impossible to surely identify the real explanation. The short data sample, the relatively small number of countries, the possibility of imperfect integration of markets and the lack of a generally accepted asset pricing model combined, make it difficult to distinguish between these possible interpretations. Although, the absence of an explanation for the winner-loser reversals in national market indices is not surprising given that researchers still differ in their assessment of the causes of price-based anomalies in the U.S. market.

Firstly, the major result of the paper is the absence of any support for the hypothesis that the reversals reflect risk differentials. No evidence suggest that returns during backtesting period of prior losers were significantly riskier than those of prior winners, while looking both on their standard deviations and their correlations with the world market return or other known risk factors. Anyway, there is evidence that winner-loser reversals are larger among the smaller markets than the larger markets, so there may be an element of a "small-country effect" or simply related to some form of market imperfection. Secondly, a possible interpretation of the results might be that reversals are the result of cross-border equity flows being insufficiently large to remove mispricing, perhaps due to investors' fears of expropriation or capital controls. Preliminary evidence for this view might be found in the observation that the contrarian strategy would have yielded below-average returns near the end of the sample period, however as it was previously mentioned, even some more recent papers identify this anomaly. Another possible interpretation could be that it may not even be realistic to expect from arbitrage to remove all price discrepancies given the uncertainty in the valuation of equities, the high volatility of returns and the apparently long time required for mispricing to be removed. Last but not least, it is possible that increases in cross-border flows may actually add to the degree of mispricing because it implies that there will be more momentum investors with aim to "jump on the bandwagon" of the moment.

Markets traded
equities
Confidence in anomaly's validity
Strong
Notes to Confidence in anomaly's validity
Period of rebalancing
3 Years
Notes to Period of rebalancing
Number of traded instruments
8
Notes to Number of traded instruments
in a sample study, it depends on investor's need for diversification
Complexity evaluation
Simple strategy
Notes to Complexity evaluation
Financial instruments
ETFs, funds
Backtest period from source paper
1969-1995
Indicative performance
6.40%
Notes to Indicative performance
per annum, performance from Table 1 Panel B for holding period 36 months
Estimated volatility
not stated
Notes to Estimated volatility
Maximum drawdown
not stated
Notes to Maximum drawdown
Sharpe Ratio
not stated

Keywords:

reversal, rotational system, country picking

Simple trading strategy

The investment universe consists of 16 ETFs (funds) which invest in individual countries equity indexes. Go long on the bottom 4 countries with the worst 36 - month return and go short on the top 4 countries with best 36-month return. Rebalance every 3 years.

Source Paper

Richards: Winner-Loser Reversals in National Stock Market Indices: Can They be Explained?
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=883937
Abstract:
This paper examines possible explanations for "winner-loser reversals" in the national stock market indices of 16 countries. There is no evidence that loser countries are riskier than winner countries either in terms of standard deviations, covariance with the world market or other risk factors, or performance in adverse economic states of the world. While there is evidence that small markets are subject to larger reversals than large markets, perhaps because of some form of market imperfection, the reversals are not just a small-market phenomenon. The apparent anomaly of winner-loser reversals in national market indices therefore remains unresolved.

Other Papers

Balvers, Wu: Momentum and mean reversion across national equity markets
http://andromeda.rutgers.edu/~yangruwu/MOM_MR_JEF.pdf
Abstract:
Numerous studies have separately identified mean reversion and momentum. This paper considers these effects jointly. Our empirical model assumes that only global equity price index shocks can have permanent components. This is motivated in a production-based asset pricing context, given that production levels converge across developed countries. Combination momentum-contrarian strategies, used to select from among 18 developed equity markets at a monthly frequency, outperform both pure momentum and pure contrarian strategies. The results continue to hold after corrections for factor sensitivities and transaction costs. They reveal the importance of controlling for mean reversion in exploiting momentum and vice versa.

Balvers, Wu, Gilliland: Stock Markets and Parametric Contrarian Investment Strategies
http://andromeda.rutgers.edu/~yangruwu/mr_jf.pdf
Abstract:
For U.S. stock prices, evidence of mean reversion over long horizons is mixed, possibly due to lack of a reliable long time series. Using additional cross-sectional power gained from national stock index data of 18 countries during the period 1969 to 1996, we find strong evidence of mean reversion in relative stock index prices. Our findings imply a significantly positive speed of reversion with a halflife of three to three and one-half years. This result is robust to alternative specifications and data. Parametric contrarian investment strategies that fully exploit mean reversion across national indexes outperform buy-and-hold and standard contrarian strategies.

Spierdijk, Bikker, Van den Hoek: Mean Reversion in International Stock Markets: An Empirical Analysis of the 20th Century
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1947305
Abstract:
This paper analyzes mean reversion in international stock markets during the period 1900-2008, using annual data. Our panel of stock indexes in seventeen developed countries, covering a time span of more than a century, allows us to analyze in detail the dynamics of the mean-reversion process. In the period 1900-2008 it takes stock prices about 13.8 years, on average, to absorb half of a shock. However, using a rolling-window approach we establish large fluctuations in the speed of mean reversion over time. The highest mean reversion speed is found for the period including the Great Depression and the start of World War II. Furthermore, the early years of the Cold War and the period covering the Oil Crisis of 1973, the Energy Crisis of 1979 and Black Monday in 1987 are also characterized by relatively fast mean reversion. Overall, we document half-lives ranging from a minimum of 2.1 years to a maximum of 23.8 years. In a substantial number of time periods no significant mean reversion is found at all, which underlines the fact that the choice of data sample contributes substantially to the evidence in favour of mean reversion. Our results suggest that the speed at which stocks revert to their fundamental value is higher in periods of high economic uncertainty, caused by major economic and political events.

Smith, Pantilei: Do 'Dogs of the World' Bark or Bite? Evaluating a Mean-Reversion-Based Investment Strategy
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2279246
Abstract:
Mean reversion in financial markets is commonly accepted as a powerful force. This paper examines the performance of a simple mean-reversion-based strategy -- Dogs of the World -- designed to take advantage of return reversals in national equity markets. Both a simulated application of the strategy using indexes since 1971 and application using single-country ETFs since 1997 produces higher compounded average returns than those of a comparable market index. Although the Dogs strategy also produces higher volatility than the index, the information ratio for the strategy suggests that the return more than compensates. An advantage of this strategy is that its implementation using single-country ETFs is straightforward and inexpensive.

Lakonishok, Schleifer, Vishny: Contrarian Investment Extrapolation and Risk
http://www.lsvasset.com/pdf/Contrarian-Investment-Extrapolation-and-Risk.pdf
Abstract:
For many years, scholars and investment proffesionals have argued that value strategies outperform the market. These value strategies call for buying stocks that have low prices relative to earnings, dividends, book assets, or other measures of fundamental value. While there is some agreement that value strategies produce higher returns, the interpretation of why they do so is more controversial. This article provides evidence that value strategies yield higher returns because these strategies exploit the suboptimal behavior of the typical investor and not because these strategies are fundamentally riskier.

Zaremba: Combining Equity Country Selection Strategies
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2616056
Abstract:
The recent rise of passive investment products granted investors easy access to international markets. The basic motivations of this paper is to offer investors new tools to allocate assets across countries. The study investigates the performance of equity country selection strategies based on combinations of theoretically and empirically motivated variables. Thus, we form portfolios and assess their performance with asset pricing models. The empirical examination is based on data from 78 within the period from 1999 to 2015. The strategies based on earnings-to-price ratio, turnover ratio and skewness prove useful tools for international investors. Furthermore, portfolios from sorts on blended rankings of skewness combined with earnings-to-price ratio or turnover ratio are also characterized by attractive risk-return relation. However, the joint strategies do not outperform the strategies based on single metrics. As a result, we argue that given the low correlations among the returns on single-variable strategies investors would be better off building a diversified portfolio of them than combining them into one strategy.

Gharaibeh: Long-Term Contrarian Profits in the Middle East Market Indices
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2684807
Abstract:
This paper examines whether there is an existence of a long-term contrarian profits at the Middle East (ME) market indices. This paper shows strong evidence for the long-term contrarian strategy in the Middle East indices. The result of this study demonstrates that the long-term contrarian profits for the Middle East markets can’t be explained by two-factor model. In spite of whether winners are smaller or larger than losers, there are long-term abnormal profits. Finally, the findings in this paper suggest that the long-term contrarian profits may be stronger and more enveloping than is usually understood.

Hypothetical future performance

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