The tendency of markets to price assets based on extrapolation of recent trends rather than realistic assessment of long-term probabilities — creating systematic over-discounting of bad news and under-discounting of good news.
“The market overreacts consistently and predictably. Contrarian investing is the systematic exploitation of this predictable irrationality.”
— David Dreman
Deeper Explanation
Market overreaction is the statistical phenomenon underlying David Dreman's empirical research on contrarian stock selection. His data showed that markets systematically overreact in both directions: they push up prices of recent winners too high (over-discounting good news and optimistic extrapolations) and push down prices of recent losers too low (over-discounting bad news and pessimistic extrapolations). The psychological mechanism is the representativeness heuristic: investors judge the probability of future outcomes by how closely the current situation resembles a prototype of past outcomes. A company with three consecutive years of strong earnings growth "looks like" a growth stock, and investors pay growth-stock valuations even when the fundamental drivers of that growth may be temporary. A company with two consecutive years of earnings disappointments "looks like" a deteriorating business, and investors price it for continued deterioration even when the underlying business may be cyclically impaired rather than permanently broken. The empirical consequence of this overreaction is the value premium: on average, across large samples and long time periods, the cheapest stocks (those that have been beaten down to extreme pessimism pricing) outperform the most expensive stocks (those priced for optimistic extrapolation). The specific mechanism is earnings surprises: cheap stocks, which have low expectations, frequently beat those expectations, triggering price recoveries; expensive stocks, which have high expectations, frequently miss them, triggering price declines. Dreman's data over multiple decades found that the most negative analyst revisions in any quarter were followed by significantly above-average stock returns over the subsequent one to three years — as overreaction to bad news created prices that discounted scenarios more pessimistic than actually materialised.
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