Data 88 – Economic Models Overreaction & Momentum October 27, 2020 Reading: De Bondt, W. F., & Thaler, R. (1985). Does the stock market overreact?. Journal of Finance , 40(3), 793-805. Jegadeesh, N., & Titman, S. (2011). Momentum. Annual Review of Financial Economics , 3(1), 493-509. L. Menkhoff, L. Sarno, M. Schmeling, A. Schrimpf, “Currency Momentum Strategies,” Journal of Financial Economics , 106 , 660–684 (2012). Lab 9: Behavioral Finance – Overreaction & Momentum R. J. Hawkins: Data 88 – Economic Models 1/ 9
Behavioral Financial Economics A capital-market example. Source: Thaler (2016) and Twitter. $16.00 $14.00 $12.00 + 70% Closing price ( $ ) − 10% $10.00 $8.00 $6.00 $4.00 Dec 18 Price $2.00 NAV $0.00 4 4 4 4 5 5 5 5 5 5 6 6 1 1 1 1 1 1 1 1 1 1 1 1 0 0 0 0 0 0 0 0 0 0 0 0 2 2 2 2 2 2 2 2 2 2 2 2 y l p v n r y l p v n r u a u a a e o a a e o a J J M N J M M N J M S S F igure 1. P rice and N et A sset V alue for CUBA F und Lab 9: Behavioral Finance – Overreaction & Momentum R. J. Hawkins: Data 88 – Economic Models 2/ 9
Momentum Why is momentum important? 1 It is the exact opposite of the mechanism that should ensure efficient markets: reversion to a fundamental value. 2 It validates the dramatically simple strategy of trend following: buy when price goes up. sell when price goes down. at the heart of the USD 325 billion Commodity Trading Advisor (CTA) industry. 3 It seems universal, both across epochs and asset classes. 4 It reveals an extremely persistent, universal bias in the behavior of investors who appear to hold “extrapolative expectations”. Lab 9: Behavioral Finance – Overreaction & Momentum R. J. Hawkins: Data 88 – Economic Models 3/ 9
Theoretical foundations of the EMH The EMH and information A market is efficient with respect to information set θ t if it is impossible to make economic profits by trading on the basis of the information set θ t . — M.C. Jensen (1978). — or — E ( P t +1 | θ t ) = P t (1 + ρ t ) where E ( P t +1 | θ t ) = the conditional expected price at time t + 1 . ρ t = the required rate of return. Lab 9: Behavioral Finance – Overreaction & Momentum R. J. Hawkins: Data 88 – Economic Models 4/ 9
Three Information-Forms of the EMH. What are the empirical implications of the EMH? Fama distinguishes three (3) types of information. This gives rise to three (3) forms of the EMH: Weak form efficiency: superior risk-adjusted profits are not possible using only past prices. Semi-strong form efficiency: superior risk-adjusted profits are not possible using any publicly available information. Strong form efficiency: superior risk-adjusted profits are not possible using publicly and privately available information. Lab 9: Behavioral Finance – Overreaction & Momentum R. J. Hawkins: Data 88 – Economic Models 5/ 9
800 The Journal of Finance Test Periods Average of 16 Three-Year Between January 1933 and December 1980 Length of Formation Period: Three Years Empirical challenges to the EMH. W. de Bondt and R. Thaler, “Does the Stock Market Overreact?” (1985) 0.20- 0. 15-] Loser Portfolio '.10 C 0.05-i A ~ ~ ~ ~ ~ 0.00 - - - - - -- - - - . - - - -0.05-r Winner Portfol io -o req p. e e~?~pvi-e s,'u-vq.ej r sr v-, i.e-s e s-r r-t so,-f 9., 0 5 10 I5 20 25 30 35 MON4TH1S AFTEn PORTFOLID FOIRATION Figure 1. Cumulative Average Residuals for Winner and Loser Portfolios of 35 Stocks (1-36 months into the test period) You can outperform using past prices! While not reported here, the results using market model and Sharpe-Lintner They are also insensitive to the choice of December as the Lab 9: Behavioral Finance – Overreaction & Momentum residuals are similar. R. J. Hawkins: Data 88 – Economic Models 6/ 9 month of portfolio formation (see De Bondt [7]). The overreaction hypothesis predicts that, as we focus on stocks that go (during the formation period), through more (or less) extreme return experiences the subsequent price reversals will be more (or less) pronounced. An easy way to generate more (less) extreme observations is to lengthen (shorten) the portfolio alternatively, for any given formation period (say, two years), formation period; we may compare the test period performance of less versus more extreme portfolios, e.g., decile portfolios (which contain an average 82 stocks) versus portfolios of 35 stocks. Table I confirms the prediction of the overreaction hypothesis. As the cumulative average residuals (during the formation period) for various sets of winner and loser portfolios grow larger, so do the subsequent price reversals, measured by [ACARL,t - ACARw,,] and the accompanying is observed t-statistics. For a formation period as short as one year, no reversal at all. Table I and Figure 2 further indicate that the overreaction phenomenon is qualitatively different from the January effect and, more generally, from season-
Momentum Menkhoff et al. on Currencies: Figures 2 & 4. Backtesting Results. 6 350 MOM(1,1) Cumulative excess returns (in %) Cumulative excess return (in %) 300 4 f = 1 month 250 MOM(6,1) 2 200 f = 6 months 0 150 -2 MOM(12,1) 100 f = 12 months 50 -4 0 -6 1980 1984 1988 1992 1996 2000 2004 2008 0 10 20 30 40 50 60 Months after portfolio formation Lab 9: Behavioral Finance – Overreaction & Momentum R. J. Hawkins: Data 88 – Economic Models 7/ 9
Momentum Menkhoff et al. on Currencies Implications of business cycle risk. Examined a number of macroeconomic indicators: Consumption, Employment, CPI, Disposable Income . . . Little evidence that the “usual suspects” have any impact on momentum returns. Momentum returns are largely disconnected from U.S. business-cycle risk. Consistent with results from studies of U.S. equity momentum. Lab 9: Behavioral Finance – Overreaction & Momentum R. J. Hawkins: Data 88 – Economic Models 8/ 9
Momentum Summing Up Underlying the efficient market hypothesis is the notion that if any predictable patterns exist in returns, investors will quickly act to exploit them, until the source of predictability is eliminated. This does not seem to be the case for momentum strategies. These strategies have been well known and have continued to generate excess profits in subsequent years. The momentum effect represents perhaps the strongest evidence against the efficient markets hypothesis. Lab 9: Behavioral Finance – Overreaction & Momentum R. J. Hawkins: Data 88 – Economic Models 9/ 9
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