THE MONETARY ENVIRONMENT AND LONG‐RUN REVERSALS IN STOCK RETURNS

• Author: Gerald R. Jensen,Luis Garcia‐Feijoo
• Date: 01 February 2014
• DOI: http://doi.org/10.1111/jfir.12026
• Published date: 01 February 2014

THE MONETARY ENVIRONMENT AND LONG‐RUN REVERSALS

IN STOCK RETURNS

Luis Garcia‐Feijoo

Florida Atlantic University

Gerald R. Jensen

Northern Illinois University

Abstract

Previous research attributes long‐run reversals to investor overreaction or tax‐motivated

trading; we offer an alternative explanation based on the monetary environment. Prices

rebound for stocks that have performed poorly over the past several years (losers);

however, the rebound occurs only during expansive monetary conditions. Winners only

reverse course when monetary conditions are restrictive. Past research shows that the

three‐factor model explains long‐run stock reversals; we show that the monetary

environment plays an instrumental role in the observation. Finally, we show that reversal

patterns are closely linked to both the monetary environment and a firm’s level of

financial constraints.

JEL Classification: G12, G32

I. Introduction

Over the past two decades, there has been increasing debate surrounding the long‐run

reversal that has been identified in stock returns. The long‐run reversal pattern first

garnered significant academic interest when DeBondt and Thaler (1985) observed that

stocks with a prolonged period of poor performance, or “loser stocks,”subsequently

outperformed “winners”by an average of 31.9% over the next five years. They attribute

this observation to overreaction, whereby investors become overly pessimistic about

stocks that are performing poorly and overly optimistic about stocks exhibiting superior

performance. A consequence of investor overreaction is that price reversals occur for

losers and winners as investors ultimately discover their opinions were too extreme.

Subsequently, researchers have advanced alternative explanations for the long‐run

reversal pattern; these explanations rely on either rational, economic investor behavior or

investor trading decisions that are based on irrational views.

The authors acknowledge helpful comments received from an associate editor, an anonymous referee, and

Werner DeBondt, Richard DeFusco, Sanjay Deshmukh, Art Durnev, Keith Gamble, Jon Garfinkel, John Geppert,

Wei Li, Jeff Madura, Amrita Nain, Manferd Peterson, Yiming Qian, Ashish Tiwari, Emre Unlu, Anand Vijh, Tong

Yao, and Tom Zorn. In addition, the paper benefited from comments received from seminar participants at the

University of Iowa, DePaul University, the University of Nebraska–Lincoln, Northern Illinois University, and at the

meetings of the 2012 Financial Management Association (Atlanta, GA). All errors and omissions are our own.

The Journal of Financial Research Vol. XXXVII, No. 1 Pages 3–25 Spring 2014

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© 2014 The Southern Finance Association and the Southwestern Finance Association

RAWLS COLLEGE OF BUSINESS, TEXAS TECH UNIVERSITY

PUBLISHED FOR THE SOUTHERN AND SOUTHWESTERN

FINANCE ASSOCIATIONS BY WILEY-BLACKWELL PUBLISHING

The explanation we offer falls most clearly into the category of rational,

economic behavior by investors. Departing from the traditional literature, our explanation

focuses on time variation in risk and risk premia. Recent theoretical and empirical

evidence suggests that stock return expectations are affected by time variation in the

funding conditions for investors and firms (e.g., Brunnermeier and Pedersen 2009; Jensen

and Moorman 2010). This research suggests that improved funding reduces risk aversion

for market makers and speculators and results in greater market liquidity.

Gertler and Gilchrist (1994) contend that small firms, due to their limited access

to funds, face greater financial constraints, which makes them more sensitive to variations

in credit conditions. Thorbecke (1997) and Jensen and Moorman (2010) find evidence

that small firms are more sensitive to shifts in monetary policy, which offers empirical

support for Gertler and Gilchrist’s claim. We extend this line of research and argue that

favorable monetary environments are most beneficial for firms that are most deficient in

funding (small firms and financially constrained firms). Likewise, restrictive monetary

environments have the most negative implications for firms that have the least access to,

and are most reliant on, external sources of funding, which again are firms of relatively

small size and high levels of financial constraints.

We investigate the relation between monetary conditions and the long‐term

reversal in stock prices for both winner and loser stocks. Our evidence supports the

contention that the prominence of the reversal pattern is conditional on the monetary

environment. In particular, a strong reversal pattern exists for losers during periods when

monetary conditions are expansive, while there is no significant reversal for losers when

monetary conditions are restrictive. We find that this observation holds even after

excluding January returns from the analysis. Furthermore, we find the most substantial

price rebound occurs for firms that are small, financially constrained, and financially

distressed, that is, firms that have characteristics that suggest they are funding deficient.

1

A comparable relation exists with winner stocks, as we find that when monetary

conditions are restrictive, small, financially constrained winners suffer the most. This

finding is consistent with the contention that the availability of financing is more

important for firms that have relatively limited access to funding sources.

Overall, our evidence supports the contention that the monetary environment is

an underlying factor that is at least partially responsible for the reversal pattern in loser and

winner stocks. Furthermore, our results provide an explanation for Fama and French’s

(1996) observation that the three‐factor model captures the long‐run reversal pattern. We

argue that small firms and financially unstable firms, which according to Fama and French

comprise a large part of the loser portfolio, are more sensitive to monetary conditions. For

such firms, the availability of financing is a prominent concern so the firms are more

dependent on the monetary environment. Based on this premise, periods evidenced by

greater availability of financing are especially beneficial for these financially constrained

firms as it provides access to capital to finance firm operations and for investors to

accumulate the stock.

1

The discussion in Fama and French (1996) describes small firms and value firms as being more susceptible to

financing problems.

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