Overpriced Winners

A strong increase in a firm’s market price over the past year is generally associated with higher future abnormal returns, consistent with the momentum  anomaly. However, for a small set of firms for which arbitrage is limited, high past returns forecast strongly negative future abnormal returns. We propose a dynamic model in which increased unwarranted optimism by a set of speculators leads to dynamic mispricing effects. Consistent with this model, we show a set of firms with high past returns, low institutional ownership, and high recent changes in short interest earns persistently low returns going forward. A strategy that goes short the overpriced winners and long other winners generates a Sharpe-ratio of 1.08; its returns cannot be explained by commonly used risk-factors.