Momentum

Momentum

Narasimhan Jegadeesh and Sheridan Titman. “Momentum” Annual Review of Financial Economics (2011)

In this paper, Jegadeesh and Titman (J and T) summarize a lot of the literature focusing on the momentum anomaly because it is quite possibly the strongest evidence against the efficient market hypothesis and has proven to be a profitable investment technique.  The momentum strategy is when an investor bases their investments on results from the previous period.  So, if a stock has performed well (poorly) in the last few months, they would invest with the idea that those companies will continue to perform well (poorly) in the next few months. Several studies show the positive returns investors enjoy when investing in this way.

J and T go through findings of previous literature, some of which are mentioned here.  The momentum strategy is profitable in all months except January.  The momentum strategy yields positive profits in most large markets around the world with notable exceptions in Asia.  Investing in portfolios based on industry momentum has mixed findings, but high momentum industries outperform low momentum industries in the six months after portfolio formation.  Growth (low book-to-market) stocks perform better than value (high book-to-market) stocks in the momentum strategy.  Less public exposure to a stock leads to a slow dissemination of public information, which can increase momentum profits.  Higher information uncertainty measured by dispersion in analyst forecasts, return volatility, and cash flow volatility predict higher momentum profits.  Stocks with higher turnover see an increase in momentum profits.  The momentum strategy is only profitable for firms with a low credit rating.  Portfolios with upward earnings forecast changes perform better than portfolios with downward earnings forecast changes.  Momentum strategies profit during times of economic expansion and low market volatility and have a negative return during down market and high volatility periods.  Sharp market reversals will result in significant losses for momentum strategies.

One main subject J and T talk about is why this momentum strategy can be profitable.  There are two possible reasons for the success of momentum strategy portfolios.  One is an under-reaction to information.  If informed investors receive delayed information, the info is only partially incorporated in the prices when first revealed to the market.  Once this information becomes common knowledge, however, the stock will go up or down to the correct amount.  This is where momentum strategy would work.  There is the initial increase when informed investors receive the info and use it some to make the stock increase, but it does not increase the full amount.  This stock will increase more as the information becomes more public, so choosing to invest in the stock based on its increase in previous months will lead to a profit in the following months while the stock realizes its potential as a result of the information disseminating to everyone.

The other possible reason for the success of momentum strategies is stock overreaction.  This comes from people who invest based on past performance, and push prices of these past winners above their fundamental values.  However, in the long run, J and T along with others observe the stock will decrease, which is attributed to the stock reverting back to its fundamental value.  After pushing past the value it should be, the stock will eventually work its way back to where it belongs.  In some cases, it may take years for it to revert back to a negative profit for the momentum portfolio, but the findings suggest that it will eventually revert back.  These two hypothesized reasons are why momentum is possibly the strongest evidence against efficient market hypothesis. The efficient market hypothesis has the underlying notion that if there are predictable patterns in returns, investors will quickly act to take advantage of them until that source of predictability is gone.  In the case of momentum strategies, it relies on investors under-reacting to information that could help their investment strategy or overreacting by pushing the price over where it should be.

In the last section, J & T update their research by presenting findings of the momentum strategy annual returns from 1990 to 2009.  The momentum strategy is profitable in 16 of the 20 years.  The most notable year where the strategy failed is 2009, when the stock market crashed.  This would fall into the category of momentum strategies performing poorly when the market reverses sharply as mentioned above.  J & T finish the paper by noting that there is by no means a consensus on what generates momentum profits, and it will be an interesting area for future research.