Long-Term, Short-Term and Time-Varying Profitability of Reversals: The Role of Market State and Volatility

Ali Fayyaz Munir, Shahrin Saaid Shaharuddin, Mohd Edil Abd. Sukor
International Journal of Economics and Business Administration, Volume VIII, Issue 2, 501-520, 2020
DOI: 10.35808/ijeba/478


Purpose: The purpose of this paper is to investigate the various patterns of contrarian trading strategy that can generate superior returns for retail investors in Pakistan Stock Exchange (PSX). Design/Methodology/Approach: To examine the long-term and short-term pattern of contrarian anomaly, the study adopts the buy-and-hold method and j-k overlapping portfolio formation procedure of Jegadeesh and Titman with slight modifications. Moreover, the study is also carried out to investigate the relation between the performance of contrarian portfolios and several market conditions to further test if the time-varying contrarian effects are context-dependent. Findings: The study findings suggest the existence of both long-term and short-term reversal effects that vary over time. Interestingly, the contrarian strategies yield higher returns during crisis periods, negative market state and higher market volatility. We show that short-term reversals, thus the payoffs to contrarian strategy, are predictable with market state which is found to be the primary predictor. The overall findings of this research lend partial support to the Adaptive Market Hypothesis (AMH) which claims that the changed stock market conditions are the main causes of time-varying behavior of market efficiency. Practical Implications: The existing literature reveals that the unchecked stock market intermediaries in PSX artificially manipulate the stock prices and earn abnormal returns at the expense of momentum or uninformed investors. The current research enables the policy makers and regulators to understand why emerging equity markets fail due to manipulations and how unsheltered investors can survive under the weak governing environment. Originality/Value: This study contributes to the existing literature on asset pricing by innovating various ways of excess returns based on contrarian trading strategy. In addition, our work contributes to the literature on the AMH by testing the impact of several stock market conditions on the time-varying profitability of contrarian strategy. There is a dearth of literature on the conditioning impact of various market states on the time-varying behavior of trading strategies in emerging markets.

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