Global and Relative Over- and Underreactions in International Stock Market Indexes

Abstract

The response of nineteen national stock market indexes to large movements in a world index is tested separately from a local investor and a U.S. perspective. There is substantial evidence that some countries overreact while others underreact. To the extent that the over- and underreactions can be anticipated, the subsequent market corrections may be anticipated as well. Applying a filter rule out-of-sample over a one-day period following the point in time of perceived under- or overreaction, significant gains are documented, which are especially pronounced on the day following a large world index movement. Consequently, the results documented here should enable investors to capitalize on mispriced country indexes.

To determine whether the corrections to the degree of under- or overreaction can be attributed to economic and market-related factors, a cross-sectional analysis is applied. This analysis determines that the correction to under- or overreaction is conditioned on the potential size of the market's speculative bubble, the economic growth surrounding the particular market, and the exchange rate volatility of the local currency at the time the under- or overreaction occurred.

JEL Classification: G12, G14