Long-term return reversals—Value and growth or tax? UK evidence

• Published in: Journal of international financial markets, institutions & money institutions & money, 2011-07, Vol.21 (3), p.347-368
• Main Authors: Wu, Yuliang, Li, Youwei
• Format: Article
• Language: English
• Subjects: Capital gains; Capital gains tax; Capital returns; Growth stocks; Investment policy; Investors; Long-term reversals; Long-term reversals Overreaction Taxes UK stock market; Overreaction; Rates of return; Stock returns; Studies; Taxes; UK stock market; United Kingdom; Value; Western Europe
• ISSN: 1042-4431; 1873-0612
• DOI: 10.1016/j.intfin.2010.12.001

This paper examines (i) whether value-growth characteristics have more power than past performance in predicting return reversals; and (ii) whether typical rational behaviour such as incentives to delay paying capital gain taxes can better explain long-term reversals than past performance. We find that value-growth characteristics generally provide better explanations for long-term stock returns than past performance. The evidence also shows that winners identified by capital gains dominate past performance winners in predicting reversals in the cross-sectional comparison. However, in the time-series analysis, when returns on capital gain winners are adjusted by the Fama and French (1996) risk factors, the predictive power of capital gain winners disappears. Our results show that capital gain winners are heavily featured as growth stocks. Return reversals in capital gain winners potentially reflect market price corrections for growth stocks. We conclude that investors’ incentives to delay paying capital gain taxes cannot fully rationalise long-term reversals in the UK market. Our results also imply that the long-term return pattern potentially reflects a mixture of investor rational and irrational behaviour.