Momentum is considered by academics as the one anomaly of the markets that defies the Efficient Market Hypothesis (EMH).
Even though the presence of the momentum is well known, momentum continues to persist.
What is momentum?
Momentum is the empirically observed tendency for rising prices to rise further. For example, a Jegadeesh and Titman (1993) study showed that stocks with strong performance over the past 3 to 12 months continue to outperform over the next 12 months. The high momentum stocks also outperform stocks with poor past performance in the next period.
The existence of momentum is a market anomaly, which finance theory has been struggling to explain. The difficulty is that an increase in asset prices, in and of itself, should not warrant further increase. Such increase, according to the efficient-market hypothesis, is warranted only by changes in demand and supply or new information (cf. fundamental analysis). We can attribute the appearance of momentum to cognitive biases, which belong in the realm of behavioral economics. The explanation is that investors are irrational (Daniel, Hirschleifer, and Subrahmanyam, 1998 and Barberis, Shleifer, and Vishny, 1998), in that they underreact to new information by failing to incorporate news in their transaction prices. However, much as in the case of price bubbles, recent research has argued that momentum can be observed even with perfectly rational traders (Crombez, 2001).
Academics and quantitative investment managers alike have documented that Momentum is one of the strongest existing anomalies. The empirical finding that the markets, stocks, and sectors that have performed well in the past tend to continue to perform well in the future. Those that performed poorly in the past tend to perform poorly in the future.
Quotes about Momentum
“A common phenomenon in the three types of analyst recommendation studies (Wall Street Journal/Zacks, Wall $treet with Louis Rukeyser, and Pros vs. Darts) is momentum. The stocks that get recomnended are those that have recently done well. In an important study Narasim Jegadeesh and Sheridan Titman (1993) document the existence of a momentum effect. Jegadeesh and Titman attribute this effect to the fact that investors underreact to the release of firm-specific information, a cognitive bias.”
Shefrin (2000) page 77
“In addition to this long-run tendency toward reversal of trends, there ia a shorter-run weak tendency toward momentum, for stock prices to continue moving in the same direction”
“In an important study Narasim Jegadeesh and Sheridan Titman (1993) document the existence of a momentum effect. Jegadeesh and Titman attribute this effect to the fact that investors underreact to the release of firm-specific information, a cognitive bias.”
“Geert Rouwenhorst (1997) documents that the momentum effect occurs on global markets.”
p300 “keep in mind that most predictions are made by extrapolating recent trends–what Werner De Bondt (1993) calls “betting on trends.”
“Daniel, Hirshleifer, and Subrahmanyam posit that momentum stems from overreaction, whereas the others propose that it stems from underreaction.”
Shefrin (2000) p102
“What causes intermediate-term momentum but long-term overreaction?”[…]”The answer is heuristic-driven bias.”
Shefrin (2000) p103
“Subsequent to De Bondt and Thaler’s findings, researchers have identified more ways to successfully predict security returns, particularly those of stocks, based on past returns. Among these findings, perhaps the most important is that of momentum (Jegadeesh and Titman 1993), which shows that movements in individual stock prices over the period of six to twelve months tend to predict future movements in the same direction. That is, unlike the long-term trends identified by De Bondt and Thaler, which tend to reverse themselves, relatively short-term trends continue.”
“First, once one moves past the very smallest stocks, the profitability of momentum strategies declines sharply with firm size. Second, holding size fixed, momentum strategies work better among stocks with low analyst coverage. Finally, the effect of analyst coverage is greater for stocks that are past losers than for past winners.”
Hong, Lim and Stein (1999)
Top 10 Papers
CHAN, L., N. JEGADEESH and J. LAKONISHOK, 1996. Momentum Strategies. NBER Working Paper. [Cited by 297]
GRINBLATT, M., S. TITMAN and R. WERMERS, 1995. Momentum investment strategies, portfolio performance, and herding: A study of mutual fund behavior. American Economic Review. [Cited by 255]
HONG, H. and J.C. STEIN, 1999. A unified theory of underreaction, momentum trading and overreaction in asset markets. The Journal of Finance. [Cited by 363]
ROUWENHORST, K.G., 1998. International Momentum Strategies. The Journal of Finance. [Cited by 216]
JEGADEESH, N., S. TITMAN and M.P. PAGE, 2001. Profitability of Momentum Strategies: An Evaluation of Alternative Explanations. The Journal of Finance. [Cited by 193]
HONG, H., et al., 2000. Bad news travels slowly: size, analyst coverage, and the profitability of momentum strategies. The Journal of Finance. [Cited by 214]
LEE, C.M.C. and B. SWAMINATHAN, 2000. Price momentum and trading volume. The Journal of Finance. [Cited by 162]
MOSKOWITZ, T.J. and M. GRINBLATT, 1999. Do Industries Explain Momentum?. The Journal of Finance. [Cited by 163]
GRUNDY, B.D. and J.S. MARTIN, 2001. Understanding the nature of the risks and the source of the rewards to momentum investing. Review of Financial Studies. [Cited by 126]
LIEW, J. and M. VASSALOU, 2000. Can book-to-market, size and momentum be risk factors that predict economic growth. Journal of Financial Economics. [Cited by 122]
Key words: Momentum, Relative Strength, Trend Following, Velocity.