Market States and Momentum

We test overreaction theories of short-run momentum and long-run reversal in the cross section of stock returns. Momentum profits depend on the state of the market, as predicted. From 1929 to 1995, the mean monthly momentum profit following positive market returns is 0.93%, whereas the mean profit following negative market returns is −0.37%. The up-market momentum reverses in the long-run. Our results are robust to the conditioning information in macroeconomic factors. Moreover, we find that macroeconomic factors are unable to explain momentum profits after simple methodological adjustments to take account of microstructure concerns. SEVERAL BEHAVIORAL THEORIES have been developed to jointly explain the shortrun cross-sectional momentum in stock returns documented by Jegadeesh and Titman (1993) and the long-run cross-sectional reversal in stock returns documented by DeBondt and Thaler (1985). 1 Daniel, Hirshleifer, and Subrahmanyam (1998; hereafter DHS) and Hong and Stein (1999; hereafter HS) each employ different behavioral or cognitive biases to explain these anomalies. 2, 3

[1]  Tarun Chordia,et al.  Momentum, Business Cycle and Time Varying Expected Returns , 2001 .

[2]  J. Campbell,et al.  By Force of Habit: A Consumption‐Based Explanation of Aggregate Stock Market Behavior , 1995, Journal of Political Economy.

[3]  J. Stein,et al.  A Unified Theory of Underreaction, Momentum Trading and Overreaction in Asset Markets , 1997 .

[4]  Robert F. Whitelaw.  Stock Market Risk and Return: An Equilibrium Approach , 1997 .

[5]  D. Hirshleifer.  Investor Psychology and Asset Pricing , 2001 .

[6]  Mark Grinblatt,et al.  Predicting stock price movements from past returns: The role of consistency and tax-loss selling , 2004 .

[7]  Robert A. Korajczyk,et al.  Are Momentum Profits Robust to Trading Costs? , 2003 .

[8]  Michael J. Cooper.  Filter Rules Based on Price and Volume in Individual Security Overreaction , 1999 .

[9]  F. Diebold,et al.  Comparing Predictive Accuracy , 1994, Business Cycles.

[10]  Kent D. Daniel,et al.  Investor Psychology in Capital Markets: Evidence and Policy Implications , 2001 .

[11]  Kent D. Daniel,et al.  Presentation Slides for 'Investor Psychology and Security Market Under and Overreactions' , 1998 .

[12]  Kent D. Daniel,et al.  NBER WORKING PAPER SERIES EVIDENCE ON THE CHARACTERISTICS OF CROSS SECTIONAL VARIATION IN STOCK RETURNS , 1996 .

[13]  Prospect Theory and Asset Prices , 1999 .

[14]  E. Fama,et al.  Multifactor Explanations of Asset Pricing Anomalies , 1996 .

[15]  Michael J. Schill,et al.  The Illusory Nature of Momentum Profits , 2004 .

[16]  Susan M. Mangiero.  International Momentum Strategies , 1998 .

[17]  T. Moskowitz,et al.  The Cross Section of Expected Returns and its Relation to Past Returns: New Evidence , 1999 .

[18]  Jacob Boudoukh,et al.  Nonlinearities in the Relation Between the Equity Risk Premium and the Term Structure , 1997 .

[19]  A. Gallant,et al.  Nonlinear Statistical Models , 1988 .

[20]  Andrew Ang,et al.  Asymmetric Correlations of Equity Portfolios , 2001 .

[21]  I. Welch.  Herding among security analysts , 2000 .

[22]  Dong-Hyun Ahn,et al.  Risk Adjustment and Trading Strategies , 2000 .

[23]  R. Thaler,et al.  Does the Stock Market Overreact , 1985 .

[24]  Eric Ghysels,et al.  On Stable Factor Structures in the Pricing of Risk: Do Time-Varying Betas Help or Hurt? , 1998 .

[25]  Narasimhan Jegadeesh,et al.  Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency , 1993 .

[26]  Jennifer Conrad,et al.  Profitability of Momentum Strategies: An Evaluation of Alternative Explanations , 2001 .

[27]  Charles M. C. Lee,et al.  Price Momentum and Trading Volume , 1998 .

[28]  Stephen M. Horan.  Book-to-Market Ratios as Predictors of Market Returns , 1999 .

[29]  Josef Lakonishok,et al.  Contrarian Investment, Extrapolation, and Risk , 1993 .

[30]  E. Fama,et al.  Common risk factors in the returns on stocks and bonds , 1993 .

[31]  A. Lo,et al.  When are Contrarian Profits Due to Stock Market Overreaction? , 1989 .

[32]  S. Nagel.  Is it Overreaction? The Performance of Value and Momentum Strategies at Long Horizons , 2001 .

[33]  John M. Griffin,et al.  Momentum Investing and Business Cycle Risk: Evidence from Pole to Pole , 2001 .

[34]  Allan Timmermann,et al.  Firm Size and Cyclical Variations in Stock Returns , 2000 .

[35]  Terrance Odean,et al.  Learning to Be Overconfident , 1997 .

[36]  Avanidhar Subrahmanyam,et al.  News Events, Information Acquisition, and Serial Correlation , 1998 .