Persistency Of The Momentum Effect: The Role Of Consistent Winners And Losers
National Chengchi University
National Central University
National Central University at Taiwan
August 28, 2015
Momentum profits, resulting from buying winners and selling losers, are robust in the stock market; however, less than 60% of winner and loser stocks remain in winner and loser groups in the subsequent formation month. This study applies duration analysis to test the persistency of the momentum effect and demonstrates that consistent winners and losers experience higher subsequent momentum profits than inconsistent winners and losers. Consistent with the information asymmetry hypothesis and the heterogeneous beliefs hypothesis, the momentum persistency is associated with size, idiosyncratic risk, institutional ownership, and trading volume. In addition, an asymmetric effect is observed — the post-formation return contributes to the winner persistency more, while the formation period return can explain the loser persistency more. The duration analysis also demonstrates that the trading volume reflects effects of both heterogeneous beliefs among investors and the momentum life cycle. The consistent momentum strategy may offer enhanced performance, despite controlling for factors associated with market risk, size, book-to-market ratio, momentum effect, and liquidity risk.
Persistency Of The Momentum Effect: The Role Of Consistent Winners And Losers – Introduction
Return continuations of individual stocks and equity indices in the intermediate term have been documented in the literature (see, e.g., Jegadeesh and Titman, 1993; Chan, Jegadeesh, and Lakonishok, 1996, Rouwenhorst, 1998; Moskowitz and Grinblatt, 1999; and Griffin, Ji, and Martin, 2003). The momentum strategy proposed by Jegadeesh and Titman (1993), taking a long position in the top decile and a short position in the bottom decile of companies ranked by prior stock returns, has become a benchmark for academics analyzing return continuation of equity and is also a suggestive strategy for practitioners. In addition to the abnormal profits for intermediate-term momentum strategies, the persistency of the momentum effect has been investigated in empirical asset pricing literatures (e.g., Lee and Swaminathan, 2000; Gutierrez Jr. and Kelley, 2008; and Chen, Chen, Hsin, and Lee, 2014). However, existing studies only examine the persistency of momentum profitability at the portfolios level, ignoring the fact that there are variations in performances at the individual firm level. Indeed, we find a large variation in post-formation performance for winner and loser stocks, and momentum profits are mostly driven by certain winner and loser stocks that exhibit performance persistency. For example, based on a six-month formation period, about 47% of winner (loser) stocks fall out of the winner (loser) portfolio immediately following formation. We find that such inconsistent winners and losers exhibit weaker performance persistency than those that remain at the winner or loser portfolio for one month following formation, which are referred to as consistent winners or losers.1 Hence, it is necessary to better understand the turnover for stocks in winner and loser portfolios and the persistency of price adjustment at the individual firm level. This study introduces a new measure of momentum persistency based on the duration of consistent winners and losers and conducts a comprehensive duration analysis at the firm level to examine whether the persistency of the momentum effect can be explained by behavioral hypotheses which has been documented in the sources of momentum profits.
Among various explanations for the momentum effect, a recent and growing body of literature demonstrates that delayed reaction models, such as the information asymmetry hypothesis and the heterogeneous beliefs hypothesis, can explain momentum profits. For the information asymmetry hypothesis, Barberis, Shleifer, and Vishny (1998) develop a theoretical model suggesting that conservatism bias can lead investors to underreact to new information, and O’Hara (2003), Sadka (2006), and Chen and Zhao (2012) show that greater information asymmetry will make investors react to a firm’s good news or bad news in a more conservative way, leading to a delayed price adjustment from new information. Moreover, in the heterogeneous beliefs hypothesis, Allen, Morris, and Shin (2006), Hong and Stein (2007), Banerjee, Kaniel, and Kremer (2009), Verardo (2009), and Makarov and Rytchkov (2012) argue that the gradual information diffusion results higher heterogeneity among investors and leads to a stronger momentum effect. This study, therefore, takes advantage of the duration of consistent winners and losers to examine whether the information asymmetry hypothesis and the heterogeneous hypothesis can determine the momentum persistency at the individual firm level.
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