Nonlinear mean reversion in stock prices

This paper provides new evidence on the time-series predictability of stock market returns by introducing a test of nonlinear mean reversion. The performance of extreme daily returns is evaluated in terms of their power to predict short- and long-horizon returns on various stock market indices and size portfolios. The paper shows that the speed of mean reversion is significantly higher during the large falls of the market. The parameter estimates indicate a negative and significant relation between the monthly portfolio returns and the extreme daily returns observed over the past one to eight months. Specifically, in a quarter in which the minimum daily return is -2% the expected excess return is 37 basis points higher than in a month in which the minimum return is only -1%. This result holds for the value-weighted and equal-weighted stock market indices and for each of the size decile portfolios. The findings are also robust to different sample periods, different indices, and investment horizons. (C) 2007 Elsevier B.V. All rights reserved.