Stock Market Integration, Return Forecastability and Implications for Market Efficiency: A Panel Study

Using a panel data set for 18 stock countries, this paper finds fairly strong integration among national equity markets. A country's stock index price can be decomposed into a common trend component and a stationary country-specific component. Results show that the 18 country indexes reverse to the world trend with a speed of 18% per year, and that the Hong Kong market converges to other markets with a speed of 22% per year or a half life of around three years. The two components can be separately estimated using maximum likelihood. The country-specific component displays substantial variability and is found to have both mean reversion over the long horizon and momentum over the short horizon. A simple parametric trading strategy exploiting simultaneously mean reversion and momentum effects produces an excess return of 16.7% per year, which exceeds those of strategies based on momentum or mean reversion separately. The excess return is statistically significant, and cannot be explained by systematic risk factors or by transaction costs. The results seem to support the behavioralist overreaction view vis-à-vis an efficient markets view.