Trading on Overshooting

Abstract

This paper presents novel evidence that individual stocks are subject to mispricing amid shocks that permanently shift the long-run relationship between the price and the fundamentals (e.g., book value). When the long-run level of the price-to-fundamentals ratio increases/decreases, the price is expected to rise/drop during the mean shift. Based on higher/lower expected returns, uninformed investors, however, incorrectly infer that the stock is currently undervalued/overvalued and increase the purchases/sales, which causes mispricing. Trading strategies that exploit subsequent reversals of the returns yield significant positive returns. Buying/shortselling closed-end mutual funds with lowest/highest mean shifts of the price-to-NAV ratio produces risk-adjusted returns of 3% to 8% per year. Overreaction to news might not explain these results.