Understanding "momentum" in stock returns

(MoneyWatch) In 1993, economist Eugene Fama and finance professor Ken French released a paper explaining that stock returns are primarily due to three factors: market risk, size risk and value risk. However, this Fama-French three-factor model didn't account for all stock returns, missing additional factors such as the momentum of stock returns. Now a recent paper sheds more light on how the momentum factor affects stock prices.

Momentum strategies have been highly profitable. For the period January 1927 through July 2012, the average annual premium has been 8.3 percent per year. On an annualized basis, the premium has been about 7 percent per year. However, momentum has been subject to occasional large crashes, such as losing 76 percent from March through September 2009.

Dong Lou and Christopher Polk, professors at the London School of Economics, approached the issue of momentum in a new and unique way. They argue that times when momentum strategies are the most crowded by arbitrage capital should be the times when those strategies are the least profitable and when long-horizon abnormal returns are the most negative. They measured the extent of momentum crowding by the past degree of abnormally high correlation among those stocks that a momentum arbitrageur would speculate on. Their premise was that "when arbitrageurs take long positions in winner stocks and short positions in loser stocks, such momentum trades can have simultaneous, temporary price impacts on all momentum stocks and thus cause return co-movement among these stocks." They called this measure "co-momentum."

Their assumption was that when co-momentum is relatively low (meaning momentum strategies aren't crowded) abnormal returns to a standard momentum strategy should be positive and not revert. Conversely, when co-momentum is relatively high, momentum strategies are crowded and abnormal returns on a standard momentum strategy should be low. In addition, when the momentum trade gets crowded, it can be destabilizing, resulting in subsequent reversal of the initial momentum returns. The following is a summary of their findings.

• Stock co-momentum strongly and positively forecasts stock returns in the following months.
• When co-momentum is relatively high, the long-run buy-and-hold returns to a momentum strategy are negative, consistent with times of relatively high amounts of arbitrage capital pushing prices further away from fundamentals.
• International data are consistent with the U.S. momentum-predictability findings. In every one of the 19 largest non-U.S. stock markets that were examined, co-momentum is negatively associated with subsequent profits from a standard momentum trading strategy.
• Country co-momentum measures tend to move together over time, with an average pair-wise correlation of 0.47, indicating times when global arbitrage capital is generally high or low.
• The results are only present for stocks with high institutional ownership.
• A strategy that only invests in momentum in those countries with low arbitrage capital and hedges out exposure to global market, size and value factors earns 18 percent per year, with a very high level of statistical significance.

The authors also examined momentum timing strategies of mutual and hedge funds and found that the typical long-short equity hedge fund decreases their exposure to the momentum factor when co-momentum is relatively high. However, the ability of hedge funds to time momentum is decreasing in the size of the fund's assets under management -- large funds are unable to time a momentum strategy as easily as small funds.

This paper was presented at the National Bureau of Economic Research in October. The following are some insights (from the leading academics) from the discussion that followed. (I want to thank University of Chicago professor Tobias Moskowitz for sharing them with me.)

• The empirical findings aren't that strong. The t-stats are barely above 2 for the main effect and, perhaps more troubling, there's no consistent pattern. When ranking on their co-momentum factor, there's only significantly weaker momentum returns for the highest quintile. This indicates the results hinge on the extremes and only the extremes, which is worrisome.
• There's no reliable relation between co-momentum and momentum returns after 1993. This is strange, since it doesn't seem likely that there was much capital chasing momentum before then. This is pretty devastating to the story of arbitrage capital determining the success of momentum strategy returns. It appears that something else is likely going on or the result is spurious.
• The most interesting part of the discussion was when an alternative explanation for the results was offered. The issue is complex, but basically it has to do with the fact that momentum crashes are only about the losers rebounding suddenly after prolonged market downturns. When co-momentum was low, losers had low market betas and/or the market didn't suddenly rise, and the losers continued to do poorly making shorting them profitable. However, when co-momentum and market betas were high and the market suddenly went into an upswing, shorting the losers creates big losses (momentum crashes). In other words, it's not a crowding effect at work, but the fact that market betas change over time. When the co-momentum measure is high, the risk of a momentum crash is high (because the market betas of the losers are also high). This alternative explanation makes more sense given the pre-1993 results.

Finally, it's important to note that momentum crashes are only about the short side. Long-only momentum doesn't suffer from these episodes.