Quantitative Momentum Research: Long-Term Return Reversal

Quantitative Momentum Research: Long-Term Return Reversal

January 9, 2015 Momentum Investing Research
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(Last Updated On: January 18, 2017)

Does the Stock Market Overreact?

Abstract:

Research in experimental psychology suggests that, in violation of Bayes’ rule, most people tend to “overreact” to unexpected and dramatic news events. This study of market efficiency investigates whether such behavior affects stock prices. The empirical evidence, based on CRSP monthly return data, is consistent with the overreaction hypothesis. Substantial weak form market inefficiencies are discovered. The results also shed new light on the January returns earned by prior “winners” and “losers.” Portfolios of losers experience exceptionally large January returns as late as five years after portfolio formation.

Core Idea:

De Bondt and Thaler (1985) reject the market efficiency hypothesis by stating that investors “overreact” to unexpected information. Stocks that experience extreme returns may have subsequent price reversals and such reversals persist in the long-term (3-5 years). They propose that “Contrarian Strategies,” which buy past losers (undervalued stocks) and sell past winners (overvalued stocks), will generate abnormal returns.

Their main findings are the following:

  1. Overreaction Phenomenon: Extreme price movements in the formation period will be followed by subsequent opposite price movement direction. The more (or less) extreme return experiences, the greater (or smaller) will be the subsequent reversals.
    • To test such reversal, the authors compute each stock’s cumulative excess returns (CU) for the prior 36 months starting in Dec 1932. The step is repeated 16 times for all nonoverlapping 3-year period between Jan 1930 and Dec 1977. On each of the 16 relevant portfolio formation dates (Dec 1932, Dec 1935,…, Dec 1977), the CUs are ranked from low to high. Firms in the top 35 stocks are assigned to winner portfolios, and firms in the bottom 35 stocks to the loser portfolios.
    • Below graph shows that “losers” based on past 16 nonoverlapping three-year formation period outperform “winners” by 24.6% over the next 3 years. Separately, losers outperform the market by 19.6%, on average, over the next thirty-six months (3 years) after portfolio formation. Winners, on the other hand, earn about 5% less than the market.
  2. For a formation as short as one year, no reversal is observed.
  3. A large proportion of the future outperformance of past long-term losers over past long-term winners is found in January.
  4. The winner portfolio has a higher CAPM Beta (1.369) than the loser portfolio (1.026).
2014-11-12 16_17_24-Momentum academic Research recap_V01.pptx - Microsoft PowerPoint (Product Activa
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

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Definitions of common statistics used in our analysis are available here (towards the bottom)




About the Author

Jack Vogel, Ph.D.

Jack Vogel, Ph.D., conducts research in empirical asset pricing and behavioral finance, and is a co-author of DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His dissertation investigates how behavioral biases affect the value anomaly. His academic background includes experience as an instructor and research assistant at Drexel University in both the Finance and Mathematics departments, as well as a Finance instructor at Villanova University. Dr. Vogel is currently a Managing Member of Alpha Architect, LLC, an SEC-Registered Investment Advisor, where he heads the research department and serves as the Chief Financial Officer. He has a PhD in Finance and a MS in Mathematics from Drexel University, and graduated summa cum laude with a BS in Mathematics and Education from The University of Scranton.


  • Michael Milburn

    Lots of Mining and Energy companies on the 36 month loser list. prices shown are Dec 26 2014 vs Dec 30 2011. (20 companies w/ largest price decline for co’s w/ mkt cap over 4B, excl ADR). (edit: sorry about the formatting – I didn’t realize the table would wrap like that)

    ABX
    Barrick Gold Corporation (USA)
    01 – Basic Materials
    10.58 – Dec 12 2014 P
    45.25 – Dec 30 2011 P
    0.23 – p ratio 36mo (10.58/45.25 in this case)

    TRQ
    Turquoise Hill Resources Ltd
    01 – Basic Materials
    3.04
    12.456
    0.24

    NEM
    Newmont Mining Corp
    01 – Basic Materials
    18.85
    60.01
    0.31

    SDRL
    Seadrill Ltd
    06 – Energy
    12.06
    33.18
    0.36

    TCK
    Teck Resources Ltd (USA)
    06 – Energy
    13.55
    35.19
    0.39

    GRPN
    Groupon Inc
    09 – Services
    8.14
    20.63
    0.39

    GG
    Goldcorp Inc. (USA)
    01 – Basic Materials
    18.35
    44.25
    0.41

    EGO
    Eldorado Gold Corp (USA)
    01 – Basic Materials
    6.15
    13.71
    0.45

    RIG
    Transocean LTD
    06 – Energy
    18.89
    38.39
    0.49

    AVP
    Avon Products, Inc.
    05 – Consumer Non-Cyclical
    9.26
    17.47
    0.53

    NUAN
    Nuance Communications Inc.
    10 – Technology
    14.45
    25.16
    0.57

    COH
    Coach Inc
    09 – Services
    37.12
    61.04
    0.61

    TLM
    Talisman Energy Inc. (USA)
    06 – Energy
    7.85
    12.75
    0.62

    CVE
    Cenovus Energy Inc (USA)
    06 – Energy
    20.63
    33.2
    0.62

    BWP
    Boardwalk Pipeline Partners, L
    12 – Utilities
    17.44
    27.67
    0.63

    FCX
    Freeport-McMoRan Inc
    01 – Basic Materials
    23.51
    36.79
    0.64

    ESV
    ENSCO PLC
    06 – Energy
    30.5
    46.92
    0.65

    JOY
    Joy Global Inc.
    02 – Capital Goods
    48.72
    74.97
    0.65

    NE
    Noble Corporation PLC
    06 – Energy
    17.33
    26.399
    0.66

    AEM
    Agnico Eagle Mines Ltd (USA)
    01 – Basic Materials
    24.35
    36.32
    0.67

  • Jack Vogel, PhD

    Thanks for the list!

  • Jonesey

    Is finding #3 written correctly?

  • Jack Vogel, PhD

    good catch, I edited #3

  • Hannibal Smith

    This study was so long ago. Has there not been any corroborating evidence since that time?

  • Jack Vogel, PhD

    Results are similar using an updated dataset.