Return Recency as U.S. Stock Return Predictor

Do naive investors overvalue (undervalue) stocks with relatively high (low) recent returns, thereby causing exploitable overpricing (underpricing)? In the April 2019 version of his paper entitled “The Impact of Recency Effects on Stock Market Prices”, Hannes Mohrschladt devises and tests a measure of this recency effect based on correlation between daily returns during a month and the number of days until the end of the month. For stocks with low (high) values of this correlation:

• Recent returns are relatively high (low) and older returns are relatively low (high).
• Naive investors overvalue (undervalue) such stocks, which therefore become overpriced (underpriced).
• There is an opportunity to exploit this effect by buying (selling) stocks with high (low) values of this variable.

His principal test is to each month sort stocks into tenths, or deciles, by prior-month recency correlation and reform an equal-weighted or value-weighted hedge portfolio that is long (short) the decile with high (low) recency correlations. He also considers a 1-year lookback interval using monthly returns rather than a 1-month interval using daily returns for calculation of recency correlations. Using daily and monthly returns and other data for a broad sample of U.S. common stocks during January 1926 through December 2016, he finds that: (more…)