Market Efficiency - Momentum

Topics: Stock market, Financial markets, Fundamental analysis Pages: 6 (1728 words) Published: October 27, 2014
Introduction

The concept of market efficiency has been a hotly debated issue in finance due to its wide ranging implications on the finance industry. The efficient market hypothesis states that market prices fully reflect the information that is publically available hence implies that there are no possibilities to attain abnormal profits (Fama 1970). Under the assumptions of an efficient market, new information should quickly and accurately be incorporated into the market price leaving no room for traders to abnormally profit. Intuitively, the assumption that traders cannot beat the market undermines many of the roles in the modern finance industry such as active portfolio management and technical analysis.

There are a plethora of research articles that try to empirically test the level of market efficiency and prove that stock prices do not follow a random walk (Lo and Mackinlay 1988). Some of these articles focus on anomalies that should not hold true in an efficient market and other articles try to dispel those anomalies. Market efficiency anomalies such as momentum, reversal effects, book-to-market effects and post-earnings-announcement drifts have contributed to the argument against the idea of market efficiency.

Momentum

Jegadeesh and Titman 1993 aimed to investigate the returns on stocks that had previously performed well (winners) and sell stocks that had previously performed badly (losers). The study showed that significant abnormal returns could be generated within the first 12 months by investing in a portfolio consisting of the top 10 per cent of winners and losers. The research and its findings relating to price momentum have been cited in many other works and forms the backbone of many discussions based on market efficiency. The results were obtained over a period from 1965 to 1989 and clearly defy the weak form of market efficiency which states that prices should already reflect historical prices (Fama 1970). The fact that Jegadeesh and Titman were able to sustain abnormal returns over such a long time horizon shows that there is a strong case against equities markets being efficient.

The momentum effect has also been observed outside of the US equities markets. Rouwenhorst (1998) showed that throughout 1980 to 1995, a trading strategy based on a portfolio consisting of relatively strong stocks could result in statistically significant returns over a 12 month period. This study was conducted on a sample of 12 European countries and the results concluded that the momentum effect that was shown by Jegadeesh and Titman was applicable in all of the sample markets and provided evidence that Jegadeesh and Titman’s work was not a result of selection bias. Rouwenhorst (1998) also stated that the abnormal returns were not attributable to investors bearing systematic risk as many critics of the momentum effect would argue.

Other articles aim to prove that the momentum anomaly is present within international markets and that strategies based on momentum are profitable and that excess returns can be realised. Marshall and Cahan (2005) showed that by using 3 different strategies, all implementing momentum bases, that excess profits were able to be made on the Australian Stock Exchange. They concluded that these trading strategies were robust and were still profitable even after risk adjustments. The strategies that they used were based on the work of Jegadeesh and Titman also that of Moskowitz and Grinblatt in 1999 that revolved around industry momentum as opposed to stock specific momentum. The most effective strategy was one that was based on the study conducted by George and Hwang in 2004 which use a 52-week high price which is readily available to the public. Again, this validates the works of Jegadeesh and Titman and that of Rouwenhorst but within the Australian equities market. Building on the works of George and Hwang (2004) and Marshall and Cahan (2005) around trading strategies based on the...

References: Fama, E. F. 1970, ‘Efficient capital markets: a review of theory and empirical work’, The Journal of Finance, vol. 25, no. 2, pp. 383-417, viewed 29 September 2013, Jstor, 2325486.
Fama, E. F. and French, K. R. 1993, ‘Common risk factors in the returns on stocks and bonds’, Journal of Financial Economics, vol. 33, no. 1, pp. 3-56, viewed 29 September 2013, ScienceDirect, doi: 0304-405X.91.05.00
George, T
Jegadeesh, N. and Titman, S. 1993, ‘Returns to buying winners and selling losers: implications for stock market efficiency’, The Journal of Finance, vol. 48, no. 1, pp. 65-91, viewed 29 September 2013, Jstor, 2328882.
Jegadeesh, N. and Titman, S. 2003, ‘Momentum’, Annual Review of Financial Economics, vol. 3, no. 12, pp. 493-509, viewed 29 September 2013, Annual Reviews, DOI: 10.1146/annurev-financial-102710-144850.
Liu, M. Liu, Q. Ma, T. 2011, ‘The 52-week high momentum strategy in international stock markets’, Journal of International Money and Finance, vol. 30, no. 1, pp. 180-204, viewed 29 September 2013, ScienceDirect, doi: 10.1016/j.jimonfin.2010.08.004.
Lesmond, D. A. Schill, M. J. and Zhou, C. 2004, ‘The illusory nature of momentum profits’, Journal of Financial Economics, vol. 71, no. 2, pp. 349-380, viewed 29 September 2013, ScienceDirect, doi: 10.1016/S0304-405X(03)00206-X.
Lo, A. W. and Mackinlay, C. 1988, ‘Stock market prices do not follow random walks: evidence from a simple specification test’, The Review of Financial Studies, vol. 1, no. 1, pp. 41-66, viewed 29 September 2013, Jstor, 2962126.
Moskowitz, T. J. and Grinblatt, M. 1999, ‘Do industries explain momentum?’, The Journal of Finance, vol. 54, no. 4, pp. 1249-1290, viewed 29 September 2013, Jstor, 798005.
Marshall, B. R. and Cahan, R. M. 2005, ‘Is the 52-week high momentum strategy profitable outside the US?’, Applied Financial Economics, vol. 15, no. 18, pp. 1259-1267, Taylor and Francis Online, doi: 10.1080/09603100500386008.
Rouwenhorst, G. K. 1998, ‘International momentum strategies’, The Journal of Finance, vol. 53, no. 1, pp. 267-284, viewed 29 September 2013, Jstor, 117441.
Siganos, A. 2010, ‘Can small investors exploit the momentum effect?’, Financial Markets and Portfolio Management, vol. 24, no. 2, pp. 171-192, viewed 29 September 2013, Springer Link, doi: 10.1007/s11408-009-0120-3.
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