I.Introduction
I will explore a special case of multiple equilibria, observed in the stock market, that is the interplay between the trend followers and the contrarians. There are two types of the multiplicity of equilibria, one originates from less informed agents behaving like trend followers, and the other equilibria originating from better-informed agents who follow contrarian strategies.
Trend-followers are those investors who buy stocks when the price is high and sell them when the price of a stock falls. However, contrarian investors trade oppositely. They buy the stock when the price is low and sell them when the price is high. To put it another way, a contrarian investor is the one who buys the stock when others are selling it and sells when others are buying the stock. These multiple equilibria of trend followers and contrarian investors are observed in the stock market trading. Academic literature on investors’ behavior confirms this interesting case of multiple equilibria. The multiple equilibria also point to the instability of the financial market. I will be talking about the evidence at great length as we proceed. But first, I would like to describe the phenomenon in detail.
The fact that the stock market has some sort of memory cannot be overlooked. Past prices of the stock have always helped predict its current price. Using this logic, trend followers can gauge the momentum of the stock to book short-term profit. Trend followers tend to capture market trends. A trend is a chain of asset prices that move consistently in one direction over a given time interval. Trend followers identify the pattern and try to trade in the direction of the trend. This is one kind of equilibrium.
Every trader bases their trades on market signals (market prices), private signals, and the information that is available in the public domain. The speculator’s decision is also dependent on past profits. When speculators start switching more frequently between the trend-following and the contrarian strategies, markets observe complex mixing of a continuation and reversal of the current price trend. If the pattern continues then prices become unpredictable and they show a random walk-like path.
The basic premise of the trend following rule is that prices will continue to trend in the same direction whereas the main assumption of the contrarian trading rule is that the price trend will reverse its direction. Trend followers buy (sell) the stock in an overvalued (undervalued) market whereas contrarians buy(sell) the stock in an undervalued (overvalued) market.
Schmitt and Westerhoff (2019) show that the impact of the trend-following and the contrarian trading rules are balanced on average. The model developed by them shows that the trend followers dominate the market in a given period and their trading behavior tends to extend the current price trend. In the other period, contrarians dominate the market and lead to a reversal of the current price trend. The interplay between these opposing trading rules leads to the random walk model. Speculators select a particular strategy by looking at its likelihood of generating profits in the past. Since prices follow a random walk, none of the rules produces regular and continuous profits. Therefore, traders keep switching from one trading to another in different periods. In some periods, the trend-following trading rule outperforms the contrarian trading rule; while in other periods, it is the other way around. Following the analysis of Schmitt and Westerhoff (2019), we can say that this multiplicity of equilibria is a reality.
The behavior of a trader is triggered by greed, fear, and belief systems. Contrarian speculator believes that the current stock price is at its highest bull peak, and it can only go down in the future. This belief leads them to sell the stock to book profits. By doing this, they avoid losses in the future because of a potential trend reversal in the price.
The world-famous Benjamin Graham, Warren Buffet, and Peter Lynch, among many others, are contrarian investors. Markets are driven by different types of investors and traders. Financial markets, in general, and stock markets in particular deal with heterogeneous agents. Different types of traders have different expectations about the future price, leading them to go for different strategies. Literature divides traders into two groups- contrarians or rational investors who believe the market price will return to its fundamental price and trend followers or irrational traders who believe that the market price will follow the historical price trend. We encounter multiple equilibria because of the two opposite forces. In one trading rule, trend followers outperform and it reinforces the current price trend. In contrarian trading strategy, the market is dominated by contrarians, and therefore what we observe is a price reversal. Having said this, one can’t ignore the multiplicity of equilibria observed in the stock market. The irregular and erratic oscillation between the two equilibria suggests a random walk model of a share price.
As mentioned earlier, stock market investors and traders consist of heterogeneous agents. However, herd behavior can reduce the degree of heterogeneity among traders. Either more trend followers or more contrarians in the stock market can lead to price stability as the mismatch between selling and buying orders is the result of extreme movements in the price.
The rest of the paper is organized are follows. Firstly, evidence for the trend followers and contrarians is discussed. In the next section, I explain if the convergence between trend followers and contrarian investors is observed in the practical world.
II.Empirical Evidence
Empirical studies have documented that different groups of traders and investors follow two different and opposite strategies in equilibrium, in both domestic and internationalmarkets. There is mounting evidence on the multiple equilibria in recent empirical studies. The fact that stock prices usually are volatile confirms the existence of equilibria in the stock market. Had the stock prices been stable and less volatile, the explanation of the theory of multiple equilibria observed in the stock market would have gone weak. Information asymmetry is one of the main reasons behind the existence of one set of agents going for trend following strategy while the other set of agents going for contrarian strategy.
Jegadeesh and Titman (1993) found that trends following the trading regime generate significant and positive returns between 1965 and 1989 and are profitable for a 3 to 12 month holding period. The momentum strategy was seen to generate a profit of up to 1% as the winner portfolios keep winning and significantly outperform loser portfolios. Watanabe(2003) finds that less informed agents tend to purchase securities upon price appreciation, while better-informed agents sell them. That is, less-informed investors behave like trend-followers, while better-informed investors follow profitable contrarian strategies. This is because the less informed agents update their beliefs more on good signals than the better informed do. Therefore at the time of market clearing, the less informed increase their demands while the latter decrease, leading to the opposite strategies. However, improvement in information accuracy has the potential to weaken the trend-following and contrarian behavior, because it removes information asymmetry among heterogeneous agents.
First, accurate information may reduce the price discount, as investors perceive less future uncertainty and thus require less return premium to hold risky assets. This implies that the loading of the price on the dividend shock will increase while that on the supply shock In case of severe information asymmetry, the interplay between trend-followers and contrarians trading tends to destabilize the price.
Wouassom (2016) showed that investors can switch back and forth from one country to the other where they find opportunities to gain profit. According to Wouassom (2016), the trend following the trading regime was consistently profitable between 1969 and 2014. It was shown that the successful momentum strategy selects stocks based on their previous performances over 9 months and then holds the portfolio for the next 3 months. This strategy yields 3% per month. The reversal effect is substantially stronger for emerging countries where it yields 1.37% per month. It remains profitable in the period post-globalization.
Errors in the processing of information by the agents lead to noticeable irrationalities in decision-making. De Bondt and Thaler (1985) argue that investors are too optimistic about past winners and too pessimistic about past losers. They suggested that investment decisions influenced by representativeness bias could move stock prices away from the level that reflects all information.
Fama and French (1988) found the tendency for prices to move from their fair value (due to positive sentiment and excess of trend followers) and then revert towards them, which is consistent with the idea that price overshooting is always followed by corrections that show apparent fluctuation around their fair values. This study points to the proposition that, in the short run, trend-followers outperform the market and in the long run, contrarians dominate the market.
Moskowitz et al. (2012), Brown and Cliff (2005) results were consistent with the view that share prices initially overreact and then revert to the fair value. Prices initially show unjustified rises, a pattern consistent with trend follower but subsequently, price falls as the unjustified rises are corrected. Conversely, periods of negative sentiment are followed by relatively high returns as the under-pricing, caused by the negative sentiment, is subsequently corrected. Hong et al. (2000) find that stocks with a slower rate of information diffusion provide more potential for momentum profits. It was pointed out that there are opportunities to profit from trading horizons of three to twelve months.
Contrarian strategy is an umbrella of different strategies that attempt to generate profits by going against the usual consensus in the market. It is usually observed that the contrarian investment strategies are designed to take long positions in losing stocks and short positions in winning stocks. I will also try to shed light on the empirical evidence of contrarian trading strategies in the literature to gain insight into the existence of the contrarian strategy premium and the psychology of speculators behind the reversal phenomenon. A contrarian investor is of the view that the path to book profits lies in selling what others are buying and buying what others are selling. Price Reversal in the equity market is a well-known phenomenon throughout the past decades. Stocks that performed poorly in the past rebound in the future.
De Bondt and Thaler (1985) first encountered the long-run reversal phenomenon in the developed market in the US stock market. The study found that losers' portfolios outperformed winners' portfolios over 3 years. Clare and Thomas (1995) studied the reversal strategies in the UK market using 1000 stocks from 1955 to 1990 to examine the existence of contrarian strategy. They found that losers outperform winners by approximately 0.142% per month. Galariotis et al. (2007) found evidence of contrarian profitability in the London Stock Exchange-listed stocks from 1964 to 2005.
Kang et al. (2002) studied the contrarian strategy in China using stock prices from the period of January 1993 to January 2000 and found that there is a significant abnormal return for some short and medium-term contrarian strategies. In addition, they discovered that there was not a distinctive effect in the medium term, which was explained by the dominance of the overreaction effect, but they were able to demonstrate that the negative cross-serial correlation can lead to contrarian profits. Chen et al. (2012) studied the contrarian trading strategies in the Chinese stock market from 1995 to 2010. They examined the performance of the trading strategies following different market states and found that contrarian strategies are profitable following down the market, especially during the economic downturn. Doan et al. (2016) examined the coexistence of momentum and contrarian strategies in the Australian equity market from 1992 to 2001. They found that contrarian strategies prevail in the intermediate and long-term.
III.Convergence
We observe that both trend followers and contrarian investors co-exist in the stock market in the short run and medium run. It is just that their weight in the market can tell us which of the trading regime outperforms the market. Since the stock market follows a random walk path, it can be very well argued that we don’t observe any convergence between the two trading regimes. As explained above, the above two trading rules are motivated by heterogeneous agents. Information asymmetry is one of the primary reasons to explain this exciting co-existence of multiple equilibria in the stock market, in particular. However, the bone of contention is now to assess if the multiple equilibria converge in the long run.
Contrarians (popularly known as fundamentalists) trade on departures of the realized price from its underlying value, whereas trend-followers (also known as chartists) trade on patterns in historical prices. These two types of trading rules dominate the academic literature. Both the rules simultaneously exist in the stock market therefore, not much can be said about its convergence.
Also, a trader can be a trend-follower for a while and after the price gives a breakout, the same trader can change the nature of the demand. That is, a trade that was going with the trend at some point will go against the trend once he observes a price breakout.
The effect of heterogeneous traders on volatility is not the same. In a practical setting, markets with a greater proportion of trend followers have higher volatility than those containing contrarians. The contrarian traders tend to weaken the market trend as they resist trends in price changes. In contrast, trend followers actively move the price away from its current value as higher demand by the trend followers tends to push the price away from the current value.
To conclude, we can say that traders don’t see a convergence in the trading regime. However, the market keeps on oscillating between the two trading regimes so that the stock follows a random- walk where stock prices become unpredictable in the long run. There are many reasons which can explain the reasons behind the existence of multiple equilibria. The two main reasons that cannot be neglected are the existence of a heterogeneous pool of investors and informational asymmetry between the traders.
