We concurrently examine price reversals and price continuations that follow extreme one-day price changes in the period 1986–2015. Consistent with the overreaction and underreaction hypotheses, we find that investors overreact to non-information-based price movements and underreact to public announcements containing firm-specific information. We also find that, consistent with the liquidity hypothesis, smaller firms and firms with lower institutional ownership are more likely to experience price reversals relative to price continuations. The magnitudes of reversals and continuations are also greater for smaller firms and firms with lower institutional ownership. Liquidity improvement following the post-decimalization period led to the reduction in the magnitudes of both, price reversals and continuations. These findings have implications for future debate about underlying reasons of observed price movements and the impact of decimalization on financial markets.
The dynamics of security prices following large price movements have received significant attention in prior literature. The impetus for this line of inquiry has been the short-run predictability of stock return patterns following large price increases or decreases. The literature has offered several explanations for the observed pricing patterns following large price movements, including the liquidity, overreaction, and underreaction hypotheses.2 A liquidity-provision-based explanation frames reversals and continuations in terms of compensation to liquidity providers for absorbing buy/sell order imbalances (Cheng, Hameed, Subrahmanyam, & Titman, 2017; Harris & Gurel, 1986; So & Wang, 2014).3 The overreaction hypothesis posits that investors overweigh current information, causing excessive trading and initial price shocks that lead to price reversals (Daniel, Hirshleifer, & Subrahmanyam, 1998; De Bondt & Thaler, 1985; De Bondt & Thaler, 1987; Park, 1995; Tetlock, 2011). On the other hand, the underreaction explanation suggests that investors are slow to respond to relevant information, which leads to price continuations (Benou, 2003; Chan, 2003; Jegadeesh & Titman, 2001; Pritamani & Singal, 2001; Savor, 2012; Zhang, 2006). In this paper, we concurrently explore the effects of the liquidity, under-, and overreaction hypotheses on both price reversals and continuations following large, one-day market-adjusted returns, both positive and negative, over the period from 1986 to 2015. To distinguish these hypotheses, we investigate how price reversals and continuations are associated with prior stock returns, excess trading volumes, liquidity variables, and firm-specific information. We first examine the likelihood of price reversals and continuations following large positive and negative price changes. The results, based on multivariate logistic regression, demonstrate significant support for the liquidity and under- (over-)reaction hypotheses. Consistent with the liquidity hypothesis, we find that reversals are more likely to occur among less liquid stocks with smaller market capitalization and lower institutional ownership.