Academic journal article International Journal of Business and Society

Profitability of Capm Momentum Strategies in the Us Stock Market

Academic journal article International Journal of Business and Society

Profitability of Capm Momentum Strategies in the Us Stock Market

Article excerpt

(ProQuest: ... denotes formulae omitted.)

1.INTRODUCTION

The momentum trading strategy has received increasing academic attention over the past two decades since the pioneering work of Jegadeesh and Titman (1993), who show that strategies of long winner stocks and short loser stocks over the past 3 to 12 months generate a monthly return of 1 percent in the US market. Similarly, Chan et al.(2000) find the existence of momentum profits in 23 international stock markets. Chong and Ip (2009) show that momentum profits exist in emerging currency markets. However, a debate still remains concerning the source of the profits and the interpretation of momentum profits. Risk-based explanations argue that momentum profits result from exposures to certain risk variables that are not priced in the traditional models of expected returns. For instance, Daniel and Titman (1999) argue that firms with high market-to-book ratios produce enhanced momentum profits. Grinblatt and Moskowitz (1999) suggest that the momentum profits can be attributed to the industry effect. Chordia and Shivakumar (2002) find evidence that macroeconomic factors perform well in capturing the variation of momentum profits. Grinblatt and Moskowitz (2003) show that growth firms have a higher momentum effect. Sagi and Seasholes (2007) identify a variety of observable firm-specific attributes that drive momentum profits. In contrast, the behavioural explanations by Barberis et al. (1998), Daniel et al. (1998) and Hong and Stein (1999) show that cognitive biases lead investors to underreact to new information, contributing to the persistent profits of the momentum trading strategy.

The empirical evidence lends support to these behavioural models as well. Fama and French (2004) demonstrate that their three-factor models cannot explain the profits of the momentum strategy. Jegadeesh and Titman (2001) show that momentum profits quickly dissipate after the investment period. Grundy and Martin (2001) and Lewellen (2002) argue that the industry effect cannot fully explain the momentum of individual stocks.

An explanation for the mixed empirical evidence is that previous studies select winner and loser stocks according to their past returns, without taking risks into account. Winner stocks may have higher market sensitivity and will rise more dramatically than the low-beta stocks when the market rallies. In addition, the difference in past returns may be due to firm-specific factors such as the firm size and book-tomarket ratio. Jegadeesh and Titman (1993) point out that past stock returns could potentially contain risk factors that would continue to affect the future stock returns. Therefore, a better way to test momentum profits is to rank stocks according to returns adjusted by the market- and firm-specific risks. In this paper, we examine the performance of risk-adjusted momentum strategies in order to shed light on the competing hypothesis for momentum profits. The strategy differs from the existing momentum strategy in that it selects past winners and losers by considering the risk-adjusted returns. Specifically, we examine the risk-adjusted momentum strategies that buy and sell stocks according to the alpha estimates of the CAPM and Fama and French (1993,1996) models. Since the trading strategy is constructed according to risk-adjusted returns, it is less influenced by market- and firm-specific risks. Hence, we can examine whether risk-adjusted momentum strategies wash away conventional momentum profits, as expected by the risk-based explanations, or remain persistently profitable, which is consistent with the behavioural explanations.

Our results show that the momentum profits based on risk-adjusted returns are significant and positively associated with the alphas. In particular, the mean momentum profit is 0.06142% per day, which is equivalent to an annualized return of 16%. The risk-adjusted momentum portfolio profits are persistent even in the down market. …

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