MOMENTUM STRATEGY

Momentum Strategy and the Taiwan Stock Exchange

Abstract

We examine whether the predictability of future returns from past returns is due to the market's underreaction to information, in particular to past earnings news. Past return and past earnings surprise each predict large drifts in future returns after controlling for the other. Market risk, size, and book-to-market effects do not explain the drifts. There is little evidence of subsequent reversals in the returns of stocks with high price and earnings momentum. Security analysts' earnings forecasts also respond sluggishly to past news, especially in the case of stocks with the worst past performance. The results suggest a market that responds only gradually to new information.

Table of Content

Introduction4

Basic Momentum Strategies5

Market Capitalization-Weighted Momentum Strategies6

Profits to Momentum Strategies6

Profits to Market Capitalization-Weighed Momentum Strategies8

Effects of Trading Volume on Momentum Profits9

Exclusion of Emerging Markets11

Different Betas in the Up and Down Markets11

Conclusion12

References14

Momentum Strategy and the Taiwan Stock Exchange

Introduction

Momentum strategies often generate attractive risk-adjusted returns. This study examines whether the profitability of international momentum trading strategies can be explained by either risk-based or behavioral-based variables or a combination thereof. The authors conclude that although these excess profits are yet unexplained, they are a result of asset mispricing in the local market and vary based on global business conditions—with the most likely explanation being changes in the business cycle.

Discussion

A form of investment that has always been popular with technical analysts but has recently started getting approval from fundamentalist investors and even the academic establishment is momentum investing.

There are two types of momentum:

momentum of price (relative strength)

momentum of earnings (increasing earnings per share)

This type of investment is the kind that causes the most irritation of all for efficient market theorists. Basically it means that trends exist and that they persist. Buy last year's highest flying stocks and you'll enjoy good results this year as well. Most investors who have been around a while will immediately recognise this as performance chasing and realise it won't work... but somehow it does seem to.

James O'Shaughnessey found evidence of price momentum in What Works on Wall Street, he found that if you bought the top 10% of large capitalisation stocks by relative strength (outperformance of the benchmark) you would have done extremely well, beating the index substantially over the next year.

He found the opposite situation also was true, if you bought the 10% of large cap stocks with the biggest drops in price over the last 12 months you would have been mauled over the next year, so much for bottom picking or contrarianism. In David Dreman's excellent book on contrarian investment Contrarian Investment Strategies: The Next Generation, Dreman notes that analysts are generally too optimistic overall, but are very much too optimistic for "good" stocks. On the other hand they are frequently far too bearish on "bad" stocks and as a result stocks that have been depressed for some time are usually wonderful value plays.

Dreman notes that contrarian stocks perform well in their first year of being a really oversold contrarian stock, but continue to ...