Does persistence in the difference in direction between overnight stock trading and intraday stock trading behaviors (tug of war) predict future returns? In their January 2019 paper entitled “Overnight Returns, Daytime Reversals, and Future Stock Returns: The Risk of Investing in a Tug of War with Noise Traders”, Ferhat Akbas, Ekkehart Boehmer, Chao Jiang and Paul Koch investigate relationships between intensity of the daily tug-of-war between between overnight (noise) and intraday (other) stock traders and future stock returns. They specify tug-of-war intensity as percentage of trading days during a month for which a stock exhibits negative (or positive) daytime reversals divided by average monthly percentage of negative (or positive) reversals over the last 12 months. They then examine whether either negative or positive tug-of-war intensity predicts future stock returns. Using overnight/intraday stock returns for a broad sample of U.S. common stocks, along with monthly returns for widely accepted factors, during May 1993 through December 2017, they find that:
- Monthly tug-of-war intensity relates negatively to future stock returns, but only for negative reversals (high opening prices).
- The equally weighted tenth (decile) of stocks with the highest frequencies of negative reversal outperforms the lowest decile by an average monthly gross 0.92%.
- Monthly gross 3-factor (market, size, book-to-market) alpha of this negative reversal hedge portfolio is 0.85%. Monthly gross 4-factor (adding momentum) alpha is 0.81%. Monthly gross 5-factor (adding profitability and investment, but not momentum) alpha is 0.88%.
- Results are stronger for stocks that are small, volatile and/or illiquid, when it is riskier to trade against noise traders. For example, among the equally weighted smallest, middle and biggest stocks by market capitalization, average monthly gross negative reversal hedge portfolio returns are 0.97%, 0.75% and 0.43%, respectively.
- Stocks with abnormally high frequencies of negative daytime reversals continue to outperform up to six months later, and outperformance does not reverse over the long run.
- Results are robust to alternative sets of control variables, subperiods and listing exchanges. They also hold for an earlier 1926-1962 sample of NYSE stocks.
- There is evidence of the effect also for SPDR S&P 500 (SPY) during 1993-2017, with the market reliably earning higher average returns after months with abnormally high frequencies of daily market-wide negative reversals, but the effect is economically very small.
In summary, evidence indicates that stocks exhibiting high negative tug-of-war (negative overnight-intraday reversal) frequencies tend to outperform over the next few months.
Cautions regarding findings include:
- Findings are gross, not net. Accounting for monthly portfolio reformation frictions and shorting costs would reduce all returns. Shorting may not always be feasible as specified due to lack of shares to borrow.
- As noted, the tug-of-war risk effect is strongest among stocks that are most costly to trade and short (and the most difficult to short). Equal weighting in portfolio analyses amplifies this concern.
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