Short-Term Reversals: The Effects of Past Returns and Institutional Exits

We present a model where the magnitude of return reversals depends on the number of informed investors as well as the number of active but uninformed investors that play a market making role. Consistent with the model, return reversals are temporarily higher following declines in the number of active institutional investors. By using stock price declines over the previous one and two quarters as instruments for unanticipated declines in active investors, we get much stronger reversals. We also show that the magnitudes of the reversals as well as their relation to prior stock price declines are lower in the post-2000 period, which is consistent with active uniformed investors (e.g., high frequency traders) reacting more quickly to changes in the number of informed investors in the more recent period.