Profits from Underreactions and Overreactions : Price Momentum and Reversal in International Stock Markets

This paper proposes a dynamic information diffusion model that explains the lead-lag reaction of stock prices resulting from the interaction of price trends and implied price risk (IPR). Consistent with our model's predictions, we construct a zero investment underreaction portfolio (overreaction portfolio) by buying low-IPR winners (low-IPR losers) and selling high-IPR losers (high-IPR winners). Our examination of international equity markets reveals strong price continuation (price reversal) for the underreaction portfolios (overreaction portfolios). Moreover, we identify market states as a significant determinant of profitability, particularly for overreaction portfolios and those in emerging stock markets. The variations in profit for conventional momentum strategies across time series and cross-sections arise from the interaction of underreaction and overreaction portfolios. Removing stocks with overreacted prices from the momentum portfolios while keeping stocks with underreacted prices can improve investment performance