Blog - Investing Notes
December 11, 2007 - When
Momentum Does and Doesn't Work
Does momentum investing have cycles, or at least better/worse
times? In their December 2007 paper entitled "Winner-minus-Loser
Return Spreads, Return Dispersion, and Changes in the Market
State", Chris Stivers and Licheng Sun investigate the
profitability of momentum investing in stocks and industries
over symmetric ranking-holding periods of 6, 18 and 36 months
relative to the state of the stock market as indicated by
recent dispersion of returns. Using monthly return
data for individual NYSE/AMEX stocks and for 48 value-weighted
industries during 1962-2005, they conclude that:
- Generally confirming prior studies:
- For 6-month ranking-holding
periods, the average winner-minus-loser (WML) return
for individual stocks is a little over 1% per month,
with the return somewhat lower in the second half of
the sample. An industry-level WML strategy generates
a positive return less than half that found for individual
stocks.
- For 18-month ranking-holding
periods, the average WML return for individual stocks
is about 0.25% per month.
- For 36-month ranking-holding
periods, the average WML return for individual stocks
is negative.
- Lagged RD reliably exhibits a negative relationship with
subsequent WML profitability for both individual stocks
and industry groups over all three tested horizons. This
relationship is particularly strong for the 18-month and
36-month horizons. For individual stocks over the entire
sample period, change in RD explains over 34% (41%) of the
variability in the subsequent 18-month (36-month) WML return.
- RD is related both to business-cycle variables/crises
and to the likelihood of major trend changes in the stock
market. Months during which the economy contracts, according
to the National Bureau of Economic Research, tend to
be preceded by relatively high values of RD. And, a relatively
high RD is associated with an elevated probability of a
change in the market, especially a good-to-bad transition,
during which the WML return is low.
- The RD-WML relationship is not substantially limited
to small stocks or fringe stocks with more subjective valuations.
The following chart, taken from the paper, displays the behaviors
of three variables over the 1962-2005 sample period:
- Return for an 18-month ranking-holding WML strategy for
individual stocks (top 10% winners minus bottom 10% losers).
- Return for an 18-month ranking-holding WML strategy for
value-weighted industry groups (top 25% winners minus bottom
25% losers).
- The lagged large-firm RD (average standard deviation of
monthly returns for the largest 10% of firms over the past
three months relative to a longer-period baseline).
Visual inspection confirms that WML (momentum) returns tend
to weaken when RD is high.
In summary, momentum investing strategies are generally
more (less) successful when the dispersion of returns across
individual stocks or industries is relatively low (high).
For related research, see Blog
Synthesis: Momentum Investing/Trading.
