Why Rising Stocks Sometimes Reverse, Then Rally

Cultural differences and investor behavior can drive reversals and momentum

Market observers know that it’s not unusual to see a stock plunge one month, only to quickly rebound the next. It’s the mirror image of the so-called “dead cat bounce,” in which a doomed stock temporarily rises on speculative buying — think Lehman Brothers in mid-2008 — then falls again. 

Instead, these short-term reversals often involve stocks that were trending upward before retail traders abruptly sold them off in reaction to potential negative news — like selling Nvidia stock when the news of DeepSeek’s supposedly low-priced AI development broke in January. Soon afterward, in this pattern, informed investors recognize a mispricing, step in to buy and drive prices back toward fundamental values. Often, these stocks then continue rising steadily afterward.

NVDA data by YCharts

This puzzling pattern — short-term (one to two months) reversals transitioning into long-term momentum (steady positive gains over three to 12 months) — is of interest to both investors and scholars. A paper forthcoming in The Review of Financial Studies, analyzing long-term stock market data from 49 countries, offers an explanation. 

Emory’s Narasimhan Jegadeesh, Nanyang Technological University’s Jiang Luo, UCLA Anderson’s Avanidhar Subrahmanyam and University of Texas’ Sheridan Titman examine the interactions among different investor groups and how they process information to integrate these two seemingly opposite phenomena — reversals and momentum — into a unified theoretical framework. Their research seeks to uncover the potential critical drivers of such stock movements, providing an advantage in asset pricing, designing trading strategies and assessing market efficiency globally.

Three Categories of Traders

The researchers suggest that the key to understanding these paradoxical patterns lies in how different groups of investors interpret and react to information. They developed a theoretical model based on three investor groups shaping these price movements: 

• Noise traders are the drivers of short-term reversals. They often — but not exclusively — include retail investors who trade based on emotion, speculation or incomplete information rather than careful analysis. Their trades can push prices away from fundamental values. However, these price distortions are temporary, as the market compensates investors willing to take the other side of noise traders’ positions. This compensation, which comes in the form of price adjustments, creates short-term reversals as prices correct toward their fundamental value.
• Uninformed investors are cautious about trusting external information they haven’t personally verified. Their skepticism causes them to respond slowly to critical market information, like earnings reports. This slow adjustment leads stock prices to only gradually reflect the true fundamentals — suggesting these investors create sustained momentum through their underreaction.
• Informed investors carefully analyze fundamental information to assess a company’s intrinsic value. Their trading helps correct mispricing caused by noise and uninformed investors and helps stabilize the market. This correction takes time, enabling momentum to persist as prices slowly align with true values.

To test predictions about reversals and momentum derived from their model, the researchers used U.S. stock data from CRSP covering the period 1931 to 2020, and international stock data from Datastream for the period 1991 to 2020. Quarterly earnings information came from Compustat for the U.S. and Worldscope for the international companies. 

The data showed short-term reversals to be notably weaker (by nearly 70%) in months following earnings announcements. The researchers suggest this is because these announcements provide clear fundamental information and reduce uncertainty, thus diminishing the impact of noise trading. 

However, the researchers suggest that the strength of reversals and momentum varies internationally due to cultural differences and market structures. They contend that:

• Cultures that experience discomfort with uncertainty and seek to avoid it experience stronger reversals as investors react more impulsively to short-term price swings.
• Cultures with greater comfort with uncertainty and less avoidance of uncertainty exhibit stronger momentum as investors allow trends driven by fundamentals to develop.

Jegadeesh, Luo, Subrahmanyam and Titman also suggest — based on their testing — that market liquidity can influence reversal and momentum patterns. They observe that markets with low liquidity had stronger short-term reversals,  likely because sophisticated investors are less active in these markets. Their absence or reduced numbers lead to fewer trades correcting price distortions. The researchers also suggest that markets with more institutional investor participation experience stronger momentum, as these informed investors trade gradually, stabilizing prices over time.

In markets dominated by retail investors, such as China and Singapore, the authors’ analysis implies momentum to be weaker overall. However, when the researchers excluded small-cap stocks that were heavily influenced by retail trading, momentum effects became clearer to see.

The research could be used to inform trading strategies around earnings announcements. The work supports the idea that reversal strategies should be used cautiously around earnings announcements as fundamental information typically reduces short-term reversal profits. It also suggests that momentum trading strategies are best used in markets with higher institutional participation while reversal trading strategies may find more success in retail-driven markets.

The study implies that investors in countries such as the U.S. and U.K., where there is less evidence of investors seeking to avoid uncertainty, may benefit more from momentum strategies, while those in high uncertainty avoidance regions such as China or Singapore might find greater success with reversal-based approaches.

Jegadeesh, Luo, Subrahmanyam and Titman’s work highlights how investor behavior, along with cultural factors and market structures, can shape stock price movements. While specific market conditions evolve, the fundamental interactions among investor types driving reversals and momentum may persist. By understanding and anticipating these hidden market forces, investors could gain an advantage in strategically harnessing reversals and momentum.