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Factor Momentum in the Chinese Stock Market
... The Chinese markets demonstrate poor performance of the conventional momentum strategy as demonstrated by studies such as Pan et al. (2013) and Gao et al. (2021). Also, since the US and China are the two largest markets in the world, this difference in their momentum patterns attracts a lot of interest from global investors (Ma et al. 2024). ...
This paper examines the existence of a well documented (Heston et al. in J Finance 65:1369–1407) (hereafter HKS 2010) intraday momentum pattern in the cross section of stock returns for three previously un-examined markets outside the US—UK, China and Brazil. While the stocks in UK and Brazil exhibit the pattern, the evidence from China is lacklustre. We utlitlize the presence of dual listed A-shares (dominated by domestic retail investors) and their B- and H-share counterparts (dominated by foreign institutional investors) of the same firms which provide a natural experiment setting to analyse the impact of investor clientele on the proliferation of HKS (2010) pattern. Our findings indicate that pattern is much weaker in A-shares (owned mostly by domestic retail investors) as compared to their B- and H-share counterparts. As a further robustness test we examine the impact of an exogenous shock that leads to an increase in institutional ownership namely the partial index inclusion of A-shares in the Morgan Stanley Capital International (MSCI) Emerging Markets Index. Our findings indicate an increasing level of the manifestation of the intraday pattern upon inclusion of A-shares to the MSCI.
This paper proposes a factor timing strategy with information from 146 characteristic‐based factors and a deep learning approach to capture the nonlinear predictability. The deep learning‐based factor timing strategy generates the highest economic value compared with the unconditional and alternative linear machine learning‐based portfolios and remains robust after controlling for traditional factor models and transaction costs. With the unique market structure of the Chinese stock market, we find that mispricing‐based theory helps explain the factor timing via deep learning.
We provide the first systematic evidence on the link between long‐short anomaly portfolio returns—a cornerstone of the cross‐sectional literature—and the time‐series predictability of the aggregate market excess return. Using 100 representative anomalies from the literature, we employ a variety of shrinkage techniques (including machine learning, forecast combination, and dimension reduction) to efficiently extract predictive signals in a high‐dimensional setting. We find that long‐short anomaly portfolio returns evince statistically and economically significant out‐of‐sample predictive ability for the market excess return. The predictive ability of anomaly portfolio returns appears to stem from asymmetric limits of arbitrage and overpricing correction persistence.
We perform a comparative analysis of machine learning methods for the canonical problem of empirical asset pricing: measuring asset risk premiums. We demonstrate large economic gains to investors using machine learning forecasts, in some cases doubling the performance of leading regression-based strategies from the literature. We identify the best-performing methods (trees and neural networks) and trace their predictive gains to allowing nonlinear predictor interactions missed by other methods. All methods agree on the same set of dominant predictive signals, a set that includes variations on momentum, liquidity, and volatility.
Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.
The conventional momentum strategy performs poorly overall in China, because stock prices behave very differently when markets are open for trading versus when they are closed. Stocks that are past intraday (overnight) winners persistently outperform those that are past intraday (overnight) losers in the subsequent intraday (overnight) periods. However, the same intraday- (overnight-) momentum strategy suffers dramatically in the subsequent overnight (intraday) periods. Further analysis shows that past intraday (overnight) winners tend to be more (less) speculative stocks which are highly demanded during the day (night). Overall, our results are consistent with investor heterogeneity, and this persistent tug of war virtually eliminate the effectiveness of investors pursuing the momentum-based trading strategy in China.
In this paper, we propose a fundamental timing strategy in both U.S. and Chinese stock markets to timing the fundamentals sorted portfolios such as value and profitability portfolios in the time‐series dimension. We find that fundamental timing strategies based on moving average (MA) timing signals could generate substantial performance gains relative to buy‐and‐hold strategies. The annualized average return of fundamental timing strategies reaches about 37% with Sharpe ratio nearly 1.30. These findings are robust to Fama–French factor model adjustment, alternative lag lengths of MA signals, holding days, and transaction costs. Moreover, the fundamental timing premium cannot be explained away by market timing or business cycle, and fundamental timing is more profitable among firms with high idiosyncratic volatility and high illiquidity.
We construct size and value factors in China. The size factor excludes the smallest 30% of firms, which are companies valued significantly as potential shells in reverse mergers that circumvent tight IPO constraints. The value factor is based on the earnings-price ratio, which subsumes the book-to-market ratio in capturing all Chinese value effects. Our three-factor model strongly dominates a model formed by just replicating the Fama and French (1993) procedure in China. Unlike that model, which leaves a 17% annual alpha on the earnings-price factor, our model explains most reported Chinese anomalies, including profitability and volatility anomalies.
In this paper, we formally show that the cross-sectional variance of stock returns is a consistent and asymptotically efficient estimator for aggregate idiosyncratic volatility. This measure has two key advantages: It is model free and observable at any frequency. Previous approaches have used monthly model-based measures constructed from time series of daily returns. The newly proposed cross-sectional volatility measure is a strong predictor for future returns on the aggregate stock market at the daily frequency. Using the cross section of size and book-to-market portfolios, we show that the portfolios' exposures to the aggregate idiosyncratic volatility risk predict the cross section of expected returns. © Michael G. Foster School of Business, University of Washington 2015.
Despite their strong positive average returns across numerous asset classes, momentum strategies can experience infrequent and persistent strings of negative returns. These momentum crashes are partly forecastable. They occur in panic states, following market declines and when market volatility is high, and are contemporaneous with market rebounds. The low ex ante expected returns in panic states are consistent with a conditionally high premium attached to the option like payoffs of past losers. An implementable dynamic momentum strategy based on forecasts of momentum’s mean and variance approximately doubles the alpha and Sharpe ratio of a static momentum strategy and is not explained by other factors. These results are robust across multiple time periods, international equity markets, and other asset classes.
We show how portfolio choice can be modeled in continuous time with transitory and persistent transaction costs, multiple assets, multiple signals predicting returns, and general signal dynamics. The objective function is derived from the limit of discrete-time models with endogenous transaction costs due to optimal dealer behavior. We solve the model explicitly and the intuitive solution is also the limit of the solutions of the corresponding discrete-time models. We show how the optimal high-frequency trading strategy depends on the nature of the trading costs, which in turn depend on dealers' inventory dynamics. Finally, we provide equilibrium implications and illustrate the model's broader applicability to micro- and macro-economics, monetary policy, and political economy.
This paper evaluates various explanations for the profitability of momentum strategies documented in Jegadeesh and Titman (1993). The evidence indicates that momentum profits have continued in the 1990s, suggesting that the original results were not a product of data snooping bias. The paper also examines the predictions of recent behavioral models that propose that momentum profits are due to delayed overreactions that are eventually reversed. Our evidence provides support for the behavioral models, but this support should be tempered with caution.
People in different cultures have strikingly different construals of the self, of others, and of the interdependence of the 2. These construals can influence, and in many cases determine, the very nature of individual experience, including cognition, emotion, and motivation. Many Asian cultures have distinct conceptions of individuality that insist on the fundamental relatedness of individuals to each other. The emphasis is on attending to others, fitting in, and harmonious interdependence with them. American culture neither assumes nor values such an overt connectedness among individuals. In contrast, individuals seek to maintain their independence from others by attending to the self and by discovering and expressing their unique inner attributes. As proposed herein, these construals are even more powerful than previously imagined. Theories of the self from both psychology and anthropology are integrated to define in detail the difference between a construal of the self as independent and a construal of the self as interdependent. Each of these divergent construals should have a set of specific consequences for cognition, emotion, and motivation; these consequences are proposed and relevant empirical literature is reviewed. (PsycINFO Database Record (c) 2012 APA, all rights reserved)
We examine the empirical properties of the payoffs to two popular currency speculation strategies: the carry trade and momentum. We review three possible explanations for the apparent profitability of these strategies. The first is that speculators are being compensated for bearing risk. The second is that these strategies are vulnerable to rare disasters or peso problems. The third is that there is price pressure in currency markets.
This paper shows that over time, expected market illiquidity positively affects ex ante stock excess return, suggesting that expected stock excess return partly represents an illiquidity premium. This complements the cross-sectional positive return–illiquidity relationship. Also, stock returns are negatively related over time to contemporaneous unexpected illiquidity. The illiquidity measure here is the average across stocks of the daily ratio of absolute stock return to dollar volume, which is easily obtained from daily stock data for long time series in most stock markets. Illiquidity affects more strongly small firm stocks, thus explaining time series variations in their premiums over time.
If returns on some stocks systematically lead or lag those of others, a portfolio strategy that sells “winners” and buys “losers”
can produce positive expected returns, even if no stock’s returns are negatively autocorrelated as virtually all models of
overreaction imply. Using a particular contrarian strategy we show that, despite negative autocorrelation in individual stock
returns, weekly portfolio returns are strongly positively autocorrelated and are the result of important cross-autocorrelations.
We find that the returns of large stocks lead those of smaller stocks, and we present evidence against overreaction as the
only source of contrarian profits.
This article studies momentum in stock returns, focusing on the role of industry, size, and book-to-market (B/M) factors.
Size and B/M portfolios exhibit momentum as strong as that in individual stocks and industries. The size and B/M portfolios
are well diversified, so momentum cannot be attributed to firm- or industry-specific returns. Further, industry, size, and
B/M portfolios are negatively autocorrelated and cross-serially correlated over intermediate horizons. The evidence suggests
that stocks covary “too strongly” with each other. I argue that excess covariance, not underreaction, explains momentum in
the portfolios.
Across markets, momentum is one of the most prominent anomalies and leads to high risk-adjusted returns. On the downside, momentum exhibits huge tail risk as there are short but persistent periods of highly negative returns. Crashes occur in rebounding bear markets, when momentum displays negative betas and momentum volatility is high. Based on ex-ante calculations of these risk measures we construct a crash indicator that effectively isolates momentum crashes from momentum bull markets. An implementable trading strategy that combines both systematic and momentum-specific risk more than doubles the Sharpe ratio of original momentum and outperforms existing risk management strategies over the 1928-2020 period, in 5 and 10-year sub-samples, and an international momentum portfolio.
We add to the emerging literature on empirical asset pricing in the Chinese stock market by building and analyzing a comprehensive set of return prediction factors using various machine learning algorithms. Contrasting previous studies for the US market, liquidity emerges as the most important predictor, leading us to closely examine the impact of transaction costs. The retail investors’ dominating presence positively affects short-term predictability, particularly for small stocks. Another feature that distinguishes the Chinese market from the US market is the high predictability of large stocks and state-owned enterprises over longer horizons. The out-of-sample performance remains economically significant after transaction costs.
This paper shows the cross-sectional and time series momentum in currencies, which cannot be explained by carry and dollar factors, summarize the autocorrelation of these factors. These momentum strategies long currency factors following positive factor returns and short them following losses. Carry and dollar factors are strongly autocorrelated and only earn significantly positive excess returns following positive factor returns. By contrast, idiosyncratic currency returns contain little momentum. Consequently, factor momentum not only outperforms the cross-sectional and time series momentum but also explains them. Limits to arbitrage and time-varying risk premium help explain factor momentum.
Most anomalies fail to hold up to currently acceptable standards for empirical finance. With microcaps mitigated via NYSE breakpoints and value-weighted returns, 65% of the 452 anomalies in our extensive data library, including 96% of the trading frictions category, cannot clear the single test hurdle of the absolute t-value of 1.96. Imposing the higher multiple test hurdle of 2.78 at the 5% significance level raises the failure rate to 82%. Even for replicated anomalies, their economic magnitudes are much smaller than originally reported. In all, capital markets are more efficient than previously recognized.
Received June 12, 2017; editorial decision October 29, 2018 by Editor Stijn Van Nieuwerburgh. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.
This study uncovers a comprehensive result of short-term momentum in the Chinese stock market. Using the traditional method to construct the momentum strategy, we find momentum performance in China is strongly related to market states, which exists when the market continues in the same state during the formation to holding periods; reverses when the market transits in two periods. By combing the traditional momentum with market dynamics, we propose a signed momentum strategy, which gains significant portfolio returns and cannot be fully explained by traditional asset-pricing factors. Our signed momentum strategy can provide practical advice for market participants.
The optimal factor timing portfolio is equivalent to the stochastic discount factor. We propose and implement a method to characterize both empirically. Our approach imposes restrictions on the dynamics of expected returns, leading to an economically plausible SDF. Market-neutral equity factors are strongly and robustly predictable. Exploiting this predictability leads to substantial improvement in portfolio performance relative to static factor investing. The variance of the corresponding SDF is larger, is more variable over time, and exhibits different cyclical behavior than estimates ignoring this fact. These results pose new challenges for theories that aim to match the cross-section of stock returns.
Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.
What capital allocation role can China’s stock market play? Counter to perception, stock prices in China have become as informative about future profits as they are in the US. This rise in stock price informativeness has coincided with an increase in investment efficiency among privately owned firms, suggesting the market is aggregating information and providing useful signals to managers. However, price informativeness and investment efficiency for state-owned enterprises fell below that of privately owned firms after the postcrisis stimulus, perhaps reflecting unpredictable subsidies and state-directed investment policy. Finally, evidence from realized returns suggests Chinese firms face a higher cost of equity capital than US firms.
Time series momentum (TSM) refers to the predictability of the past 12-month return on the next one-month return and is the focus of several recent influential studies. This paper shows that asset-by-asset time series regressions reveal little evidence of TSM, both in- and out-of-sample. While the t-statistic in a pooled regression appears large, it is not statistically reliable as it is less than the critical values of parametric and nonparametric bootstraps. From an investment perspective, the TSM strategy is profitable, but its performance is virtually the same as that of a similar strategy that is based on historical sample mean and does not require predictability. Overall, the evidence on TSM is weak, particularly for the large cross section of assets.
We take up Cochrane's (2011) challenge to identify the firm characteristics that provide independent information about average U.S. monthly stock returns by simultaneously including 94 characteristics in Fama-MacBeth regressions that avoid overweighting microcaps and adjust for data-snooping bias. We find that while 12 characteristics are reliably independent determinants in non-microcap stocks from 1980 to 2014 as a whole, return predictability sharply fell in 2003 such that just two characteristics have been independent determinants since then. Outside of microcaps, the hedge returns to exploiting characteristics-based predictability also have been insignificantly different from zero since 2003. (JEL G12, G14)
This study examines the momentum effect in the returns of factor premia representing a broad set of stock market strategies. Using cross-sectional and time-series tests, we investigate the performance persistence of market, value, size, momentum, low-risk, and quality premia within a sample of 24 international equity markets for the years 1990-2016. We provide strong evidence that the top performing factors continue to outperform the worst performing factors both in individual equity markets and in the cross-country framework. The momentum in factor premia is largely explained by the classic stock-level momentum effect.
Recent studies suggest that momentum returns are conditioned by market states, but we find that China is different. First, we find that momentum returns in China exclusively follow DOWN markets contrary to the U.S. evidence. Second, the absence of momentum returns following UP markets in China cannot be explained by market dynamics, unlike in the U.S. Third, momentum returns in China are higher when the market continues in the same state than when it transitions to the other state as in the U.S. but this is true in China only following DOWN states.
We study the Chinese stock market crash of 2015. We find that Chinese investors overreact to the government policies that may boost the stock market. This overreaction creates the equity bubble and eventually results in the stock market crash. We also find that fiscal policies excite the equity market more than monetary policies.
This paper investigates whether stock prices reflect information about future earnings contained in the accrual and cash flow components of current earnings. The extent to which current earnings performance persists into the future is shown to depend on the relative magnitudes of the cash and accrual components of current earnings. However, stock prices are found to act as if investors "fixate" on earnings, failing to reflect fully information contained in the accrual and cash flow components of current earnings until that information impacts future earnings.
A five-factor model directed at capturing the size, value, profitability, and investment patterns in average stock returns performs better than the three-factor model of Fama and French (FF, 1993). The five-factor model's main problem is its failure to capture the low average returns on small stocks whose returns behave like those of firms that invest a lot despite low profitability. The model's performance is not sensitive to the way its factors are defined. With the addition of profitability and investment factors, the value factor of the FF three-factor model becomes redundant for describing average returns in the sample we examine.
This paper provides an alternative test of Amihud and Mendelson's (1986, Journal of Financial Economics, 8, 31–35) model using the turnover rate (number of shares traded as a fraction of the number of shares outstanding) as a proxy for liquidity. The evidence suggests that liquidity plays a significant role in explaining the cross-sectional variation in stock returns. This effect persists after controlling for the well known determinants of stock returns like the firm-size, book-to-market ratio and the firm beta. Unlike Eleswarapu and Reinganum (1993, Journal of Financial Economics, 34, 373–386), this paper finds that the liquidity effect is not restricted to the month of January alone and is prevalent throughout the year. The evidence supports Amihud and Mendelson's (1986) notion of liquidity premium and establishes its role in the overall cross section of stock returns.
This paper examines the effect of controlling shareholders on stock price synchronicity by focusing on two salient corporate governance features in a concentrated ownership setting, namely, ultimate cash flow rights and the separation of voting and cash flow rights (i.e., excess control). Using a unique dataset of 654 French listed firms spanning 1998–2007, this study provides evidence that stock price synchronicity increases with excess control, supporting the argument that controlling shareholders tend to disclose less firm-specific information to conceal opportunistic practices. Additionally, this study shows that firms with substantial excess control are more likely to experience stock price crashes, consistent with the conjecture that controlling shareholders are more likely to hoard bad information when their control rights exceed their cash flow rights. Another important finding is that firms’ stock prices are less synchronous and less likely to crash when controlling shareholders own a large fraction of cash flow rights. This is consistent with the argument that controlling shareholders have less incentive to adopt poor disclosure policies and to accumulate bad news, since high cash flow ownership aligns their interests with those of minority investors.
Existing research does not find significant momentum profits in many emerging markets including China. We propose an alternative momentum strategy which groups stocks into return intervals rather than percentiles. We apply the method to the China A-share market and find economically significant momentum profits in weekly returns, but not in monthly returns. The weekly momentum lasts for about 1 year. More than half of the profit is realized in the first 3 weeks. We apply the method to other Asian equity markets and find significant weekly momentum in Hong Kong, Taiwan, Korea, Thailand, and Indonesia. These findings suggest that momentum may exist in different formats in different markets. Existence of momentum in a closed equity market like China supports momentum is pervasive in short-term stock returns.
In this paper we investigate the effects of informed trading (PIN) and information uncertainty in determining price momentum. We find that trading strategies based on buying high-uncertainty good-news stocks and shorting high-uncertainty bad-news stocks work well when limited to high-PIN stocks, while stocks with low-PIN do not exhibit price continuations, even when the uncertainty level of those stocks is high. In contrast, momentum returns are always significant for high-PIN stocks, irrespective of information uncertainty. Overall, we show that the informed trading effect is both independent of and stronger than that of information uncertainty in determining price momentum.
We use religious background as a proxy for gambling propensity and investigate whether geographical variation in religion-induced gambling norms affects aggregate market outcomes. We examine four economic settings in which the recent literature has suggested a role for gambling and speculation. Our key conjecture is that gambling propensity would be stronger in regions with higher concentration of Catholics relative to Protestants. Consistent with our conjecture, we find that religion-induced gambling preferences influence the portfolio decisions of institutional investors. Investors located in regions with high Catholic-Protestant ratio (CPRATIO) exhibit a stronger propensity to hold stocks with lottery features. Further, in a corporate setting, we show that broad-based employee stock option plans, which are likely to appeal more to employees with stronger gambling preferences, are more popular in high CPRATIO regions. Examining the aggregate impact of gambling on stock returns, we find that the initial day return following an initial public offering is higher for firms located in high CPRATIO regions where local speculative demand is expected to be stronger. In a broader market setting, we find that the magnitude of the negative lottery-stock premium is larger in high CPRATIO regions. Collectively, our results indicate that religious beliefs, through their influence on gambling attitudes, impact investors' portfolio choices, corporate decisions, and stock returns. (EFA discussant), and seminar participants at the EFA Meetings (Bergen), the NBER Behavioral Finance Meeting, the Yale Behavioral Finance Conference, UT-Austin, and NFA Meetings (Niagara-on-the-Lake) for helpful discussions and valuable comments. We also thank Garrick Blalock, Will Goetzmann, and Jacqueline Yen for the lottery sales data. We are responsible for all remaining errors and omissions. Abstract – We use religious background as a proxy for gambling propensity and investigate whether geographical variation in religion-induced gambling norms affects aggregate market outcomes. We examine four economic settings in which the recent literature has suggested a role for gambling and speculation. Our key conjecture is that gambling propensity would be stronger in regions with higher concentration of Catholics relative to Protestants. Consistent with our conjecture, we find that religion-induced gambling preferences influence the portfolio decisions of institutional investors. Investors located in regions with high Catholic-Protestant ratio (CPRATIO) exhibit a stronger propensity to hold stocks with lottery features. Further, in a corporate setting, we show that broad-based employee stock option plans, which are likely to appeal more to employees with stronger gambling preferences, are more popular in high CPRATIO regions. Examining the aggregate impact of gambling on stock returns, we find that the initial day return following an initial public offering is higher for firms located in high CPRATIO regions where local speculative demand is expected to be stronger. In a broader market setting, we find that the magnitude of the negative lottery-stock premium is larger in high CPRATIO regions. Collectively, our results indicate that religious beliefs, through their influence on gambling attitudes, impact investors' portfolio choices, corporate decisions, and stock returns.
Momentum is primarily driven by firms' performance twelve to seven months prior to portfolio formation, not by a tendency of rising and falling stocks to keep rising and falling. Strategies based on recent past performance do generate positive returns, but are less profitable than strategies based on intermediate horizon past performance, especially among the largest, most liquid stocks. The performance of two types of strategies are correlated, however, even when explicitly constructed to be neutral with respect to the past performance characteristic on which the other strategy is formed, especially over the second half of the CRSP sample. As a result, over the last forty years strategies based on recent past performance do not contribute significantly to the investment opportunity set of an investor already trading momentum based on inter-mediate horizon past performance and the three Fama-French factors. These facts are not particular to the momentum observed in the cross-section of US equities. Similar results hold for momentum strategies trading international equity indices, commodi-ties and currencies.
This study explores the role of investor sentiment in a broad set of anomalies in cross-sectional stock returns. We consider a setting where the presence of market-wide sentiment is combined with the argument that overpricing should be more prevalent than underpricing, due to short-sale impediments. Long-short strategies that exploit the anomalies exhibit profits consistent with this setting. First, each anomaly is stronger - its long-short strategy is more profitable - following high levels of sentiment. Second, the short leg of each strategy is more profitable following high sentiment. Finally, sentiment exhibits no relation to returns on the long legs of the strategies.
This paper documents that investors are more likely to hold, buy, and sell the stocks of Finnish firms that are located close to the investor, that communicate in the investor's native tongue, and that have chief executives of the same cultural background. The influence of distance, language, and culture is less prominent among the most investment-savvy institutions than among both households and less savvy institutions. Regression analysis indicates that the marginal effect of distance is less for firms that are more nationally known, for distances that exceed 100 kilometers, and for investors with more diversified portfolios.
I describe asset price dynamics caused by the slow movement of investment capital to trading opportunities. The pattern of price responses to supply or demand shocks typically involves a sharp reaction to the shock and a subsequent and more extended reversal. The amplitude of the immediate price impact and the pattern of the subsequent recovery can reflect institutional impediments to immediate trade, such as search costs for trading counterparties or time to raise capital by intermediaries. I discuss special impediments to capital formation during the recent financial crisis that caused asset price distortions, which subsided afterward. After presenting examples of price reactions to supply shocks in normal market settings, I offer a simple illustrative model of price dynamics associated with slow-moving capital due to the presence of inattentive investors. Copyright (c) 2010 the American Finance Association.
The empirical relationship between earnings' yield, firm size and returns on the common stock of NYSE firms is examined in this paper. The results confirm that the common stock of high E/P firms earn, on average, higher risk-adjusted returns than the common stock of low E/P firms and that this effect is clearly significant even if experimental control is exercised over differences in firm size. On the other hand, while the common stock of small NYSE firms appear to have earned substantially higher returns than the common stock of large NYSE firms, the size effect virtually disappears when returns are controlled for differences in risk and E/P ratios. The evidence presented here indicates that the E/P effect, however, is not entirely independent of firm size and that the effect of both variables on expected returns is considerably more complicated than previously documented in the literature.
Stock prices move together more in poor economies than in rich economies. This finding is not due to market size and is only partially explained by higher fundamentals correlation in low-income economies. However, measures of property rights do explain this difference. The systematic component of returns variation is large in emerging markets, and appears unrelated to fundamentals co-movement, consistent with noise trader risk. Among developed economy stock markets, higher firm-specific returns variation is associated with stronger public investor property rights. We propose that strong property rights promote informed arbitrage, which capitalizes detailed firm-specific information.
We argue that arbitrage is limited if rational traders face uncertainty about when their peers will exploit a common arbitrage opportunity. This synchronization risk—which is distinct from noise trader risk and fundamental risk—arises in our model because arbitrageurs become sequentially aware of mispricing and they incur holding costs. We show that rational arbitrageurs “time the market” rather than correct mispricing right away. This leads to delayed arbitrage. The analysis suggests that behavioral influences on prices are resistant to arbitrage in the short and intermediate run.
The tendency of some investors to hold on to their losing stocks, driven by prospect theory and mental accounting, creates a spread between a stock's fundamental value and its equilibrium price, as well as price underreaction to information. Spread convergence, arising from the random evolution of fundamental values and the updating of reference prices, generates predictable equilibrium prices interpretable as possessing momentum. Empirically, a variable proxying for aggregate unrealized capital gains appears to be the key variable that generates the profitability of a momentum strategy. Controlling for this variable, past returns have no predictability for the cross-section of returns.
In this paper, we analyze momentum strategies that are based on reward–risk stock selection criteria in contrast to ordinary momentum strategies based on a cumulative return criterion. Reward–risk stock selection criteria include the standard Sharpe ratio with variance as a risk measure, and alternative reward–risk ratios with the expected shortfall as a risk measure. We investigate momentum strategies using 517 stocks in the S&P 500 universe in the period 1996–2003. Although the cumulative return criterion provides the highest average monthly momentum profits of 1.3% compared to the monthly profit of 0.86% for the best alternative criterion, the alternative ratios provide better risk-adjusted returns measured on an independent risk-adjusted performance measure. We also provide evidence on unique distributional properties of extreme momentum portfolios analyzed within the framework of general non-normal stable Paretian distributions. Specifically, for every stock selection criterion, loser portfolios have the lowest tail index and tail index of winner portfolios is lower than that of middle deciles. The lower tail index is associated with a lower mean strategy. The lowest tail index is obtained for the cumulative return strategy. Given our data-set, these findings indicate that the cumulative return strategy obtains higher profits with the acceptance of higher tail risk, while strategies based on reward–risk criteria obtain better risk-adjusted performance with the acceptance of the lower tail risk.
Morck, Yeung and Yu show that R2 is higher in countries with less developed financial systems and poorer corporate governance. We show how control rights and information affect the division of risk bearing between managers and investors. Lack of transparency increases R2 by shifting firm-specific risk to managers. Opaque stocks with high R2s are also more likely to crash, that is, to deliver large negative returns. Using stock returns from 40 stock markets from 1990 to 2001, we find strong positive relations between R2 and several measures of opaqueness. These measures also explain the frequency of crashes.
We develop a theory of market crashes based on differences of opinion among investors. Because of short-sales constraints,
bearish investors do not initially participate in the market and their information is not revealed in prices. However, if
other previously bullish investors bail out of the market, the originally bearish group may become the marginal “support buyers,”
and more will be learned about their signals. Thus accumulated hidden information comes out during market declines. The model
explains a variety of stylized facts about crashes and also makes a distinctive new prediction—that returns will be more negatively
skewed conditional on high trading volume.
When coupled with a stock's current price, a readily available piece of information-the 52-week high price-explains a large portion of the profits from momentum investing. Nearness to the 52-week high dominates and improves upon the forecasting power of past returns (both individual and industry returns) for future returns. Future returns forecast using the 52-week high do not reverse in the long run. These results indicate that short-term momentum and long-term reversals are largely separate phenomena, which presents a challenge to current theory that models these aspects of security returns as integrated components of the market's response to news. Copyright 2004 by The American Finance Association.