What an interesting question, "Does the stock market overreact?"
To understand whether a mechanical trading system could work, it might be useful to understand a little more about the answer to this question...
In days gone by, and a land far far away, investors used to believe that the market did 'overshoot'. This belief was built more on instinct and personal observation than any research or specific analysis.
That was until December 1985.
A paper presented to the annual meeting of the American Finance Association sought to address this question. In short, the analysis of it's authors - Thaler and DeBondt - was that YES (!) stock markets do indeed overreact.
They demonstrated how new information about a stock or market was taken into account and given too much weight when compared to all the information that had passed before. This extra weight clouded the judgement of otherwise rational investors.
They concluded that this makes stock prices overshoot - in both directions - to such a regular degree that the overshoot and size of overshoot can be predictable. Then in time, these prices would 'regress to the mean' which is a technical way of saying that prices will generally move back to the average.
