How Investors Overreact During Bull and Bear Markets?

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Recently, equity market indices have been hitting new all-time highs. Some traders are even expressing frustration, claiming the markets are irrational and predicting a correction. Are investors overreacting in this market and pushing the indices higher?

Reference [1] examined the investor overreaction. The study is grounded in the widely recognized notion that investor sentiment plays a crucial role in shaping market dynamics.

According to the investor overreaction hypothesis, during bull (bear) markets, investors may become overly optimistic (pessimistic), potentially leading to an overreaction. Such overreactions can trigger market corrections, characterized by swift and substantial price movements in the opposite direction of the initial sentiment shift.  The author pointed out,

The study first develops two testable hypotheses that can be used to uncover the presence of stock market overreaction with subsequent correction. These hypotheses are then tested using long-term data from the US market. The empirical results not only confirm the hypotheses but also reveal a significant asymmetry in stock price overreaction between bull and bear markets. In particular, the findings suggest that investors typically overreact by the end of a bear market, leading to a quick and strong price correction at the beginning of the next bull market. On the other hand, investors seem to overreact only towards the end of a prolonged bull market. Crucially, price corrections during a bear market are not limited to the initial phase but extend throughout its entire duration.

In short, investors only overreact towards the end of a prolonged bull market. However, they do tend to overreact during a bear market throughout its entire duration.

Does this imply that the investors are not overreacting in the current bull market, and it can go even higher?

Let us know what you think in the comments below or in the discussion forum.

References

[1] Zakamulin, Valeriy, Stock Price Overreaction: Evidence From Bull and Bear Markets (2023). SSRN: https://ssrn.com/abstract=4418018

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