This is a very important paper for understanding the behavioral finance causes of directional price drifts (trends). It's finding of underreaction to new information up to 12 months matches up with the momentum factor. It also finds that over longer periods, investors do overreact and bid prices far enough that they reverse. These theories are central to explaining our trend systems which are designed to exploit directional trends (momentum) which is caused by underreaction and countertrend systems that define extreme overreaction.

A Model of Investor Sentiment.pdf

By Nicholas Barberis, Andrei Shleifer, and Robert Vishny

ABSTRACT:

Recent empirical research in nance has uncovered two families of pervasive regularities: underreaction of stock prices to news such as earnings announcements, and overreaction of stock prices to a series of good or bad news. In this paper, we present a parsimonious model of investor sentiment, or of how investors form beliefs, which is consistent with the empirical ndings. The model is based on psychological evidence and produces both underreaction and overreaction for a wide range of parameter values.

FROM THE INTRODUCTION:

Recent empirical research in nance has identied two families of pervasive
regularities: underreaction and overreaction. The underreaction evidence
shows that over horizons of perhaps one to twelve months, security prices
underreact to news.1 As a consequence, news is incorporated only slowly
into prices, which tend to exhibit positive autocorrelations over these hori-
zons. A related way to make this point is to say that current good news has
power in predicting positive returns in the future. The overreaction evidence
shows that over longer horizons of perhaps three to ve years, security prices
overreact to consistent patterns of news pointing in the same direction. That
is, securities that have had a long record of good news tend to become over-
priced and have low average returns afterwards. Put differently, securities
with strings of good performance, however measured, receive extremely high
valuations, and these valuations, on average, return to the mean.

The evidence presents a challenge to the efficient markets theory because
it suggests that in a variety of markets, sophisticated investors can earn supe-
rior returns by taking advantage of underreaction and overreaction without
bearing extra risk. The most notable recent attempt to explain the evidence
from the efficient markets viewpoint is Fama and French (1996). The au-
thors believe that their three-factor model can account for the overreaction
evidence, but not for the continuation of short-term returns (underreaction).
This evidence also presents a challenge to behavioral nance theory because
early models do not successfully explain the facts

Barberis, Shleifer and Vishny (1998)