1 “ Overreaction ” and “ Underreaction ” : - Evidence for the Portuguese Stock Market -

In the past two decades several studies show and explain the occurrence of financial phenomena that are contrary to the Efficient Markets Hypothesis (EMH) of Fama (1970). Among them, the phenomena of “overreaction” and “underreaction”, inspired by cognitive psychology studies, are one of the most important challenges to market efficiency, and helped to build the foundations of Behavioral Finance. We investigate the existence of both these phenomena in the Portuguese Stock Market and try to conciliate their simultaneous occurrence. We thus explore whether Portuguese stock returns are related to return past performance for an extended sample (all stocks listed in the main market) and time period (16 years). We start by exploring the existence of autocorrelation in stock returns: as in previous studies we evaluate whether there is negative autocorrelation in the long run, and positive autocorrelation in the short run. We then proceed in testing whether these phenomena stem from overreaction and underreaction by investors. We use several different testing methodologies to evaluate the robustness of the results (controlling for risk and non-risk factors) and assess the validity of alternative hypotheses that have been put forward to explain continuation and reversal patterns in returns. Finally we examine our findings at the light of the predictions that come out of the theoretical behavioral models that have been developed to explain momentum and reversal in returns. Our results seem to be supportive of the overreaction hypothesis: there is negative correlation in stock returns that is robust to risk and non-risk controls. Further “value” strategies show superior performance and this performance seems to be associated with extrapolation of past sales performance. As for the short run return pattern, we find weak evidence in support of momentum effects that persist after controlling for risk. The momentum effects seem to be associated with an insufficient reaction to earnings announcements surprises. The evidence we gather for the Portuguese stock market is consistent with the results found in well researched, large, liquid developed markets. Altogether the two pieces of evidence (continuation followed by reversal in returns) might reflect the dynamic interaction between “news watchers” and “momentum traders” predicted by the behavioral model of Hong and Stein (1999).