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1. Introduction
In March 2009, the US Stock Market witnessed its lowest value since the subprime mortgage crisis. An increase in stock market values was expected to follow the downturn and, indeed, equity prices did then go up significantly, recording an increase of more than 30 per cent by the end of the year. Such movements in equity prices can be seen in the context of the long-debated mean reversion or efficient market hypothesis (EMH) (weak-form) which is one of the most important traditional finance theories. The seminal work by Fama (1970) defined a financial market as informationally efficient if agents cannot obtain abnormal returns based on the information available at the time the investment is made. Whether the EMH holds or not has important economic implications for investors and asset pricing. If the EMH holds, then stock prices can be characterized as a random walk with a unit root (non-stationary). This implies that any shock to the level of a stock price has a permanent effect and the stock price will not return to its trend path in the long run. Therefore, future returns cannot be forecasted by past movements in stock prices. A random walk in stock prices also implies that volatility in equity markets will rise without bound over time. By contrast, if the EMH does not hold, then stock prices follow a mean- or trend-reverting (stationary) process. From an investment perspective, investors have the opportunity to predict future movements in stock prices relying on historical behaviour so as to earn excess returns. For example, if stock prices are mean reverting in the long run, then lower returns are followed by higher expected future returns, which could encourage the investment in equities after a downturn in the share market.
A number of reasons have been advanced to explain the presence of market inefficiency, such as the stock market overreaction hypothesis (De Bondt and Thaler, 1985, 1987), investor opportunism (Poterba and Summers, 1988), the role of leveraging (Chan, 1988 and Ball and Kothari, 1989), the size of the stocks and the associated risk factors (Zarowin, 1990 and Richards, 1997) and micro-structure/liquidity effects related to low-priced stocks (Conrad and Kaul, 1993 and Ball et al. , 1995). Mean-reversion in share prices may also...