Market Efficiency – Momentum

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 Macmillan 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.

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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 Jadedness and Titian 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 rises should already reflect historical prices (Fame 1970). The fact that Jadedness and Titian 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 useless markets. Roundhouse (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 hon. by Jadedness and Titian was applicable In all of the sample markets and provided evidence that Jadedness and Titman’s work was not a result of selection bias.

Roundhouse (1998) also stated that the abnormal returns were not attributable 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 realized. Marshall and Canaan (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 Jadedness and Titian also that of Animosity and Granulating 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 Wang in 2004 which use a 52-week high price which is readily available to the public. Again, this validates the works of Jadedness and Titian and that of Roundhouse but within the Australian equities market.

Building on the works of George and Wang (2004) and Marshall and Canaan (2005) around trading strategies based on the 52-week high, Lie, Lie and Ma (2011) aimed to test these strategies in international markets. The conclusion was that 18 out of the 20 sample countries exhibited a profit when implementing a momentum trading strategy based on the 52-week high. The results of the study could not be explained by systematic risk models or behavioral models such as anchoring of purchase price.

Similar to the studies conducted prior, the work of Lie, Lie and Ma there is support that momentum strategies are not Just a product of taking on additional market risk. Signing (2010) conducted empirical studies to prove that smaller investors could practically implement momentum trading strategies to earn profits. The study was done using I-J data and tested momentum trading strategies over 3, 6 and 9 month periods. Transaction costs such as short-selling costs, commissions and bid-ask spreads are used as a limitation in the exploitation of the momentum anomaly.

The results proved that excess profits could be made even after taking into account the transaction costs involved. Explanations and Criticisms of Momentum Fame and French (1993) try to explain the presence of a risk premium associated with stocks exhibiting high and low momentum. By using their three-factor model, they to explain that the returns are simply functions of systematic risk. The articles that test these assumptions take into account risk adjusted returns (Roundhouse 1998), (Marshall and Canaan 2005) and (Lie, Lie and Ma 2011).

The empirical results still return a profit that is abnormal is after factoring in risk as Fame and French tried to explain. It is interesting though that the profits from George and Wang (2004) were to significantly excessive after adjusting for risk. Another criticism of the effectiveness of momentum trading strategies is that that transaction costs are too high to actually exploit (Lessons, Chill and Chou 2004). Trading high and low momentum stocks. Momentum is explained to be more of an under reaction to new news, creating a lagged effect on market prices.

Signing (2010) showed in his study that both smaller investors and institutional investors could both profit from momentum trading strategies even after risk and transaction costs were factored in. The fact that both risk and transaction costs were factored into the turns and that abnormal returns still ensued is a sign that momentum is still hard to explain and factor away. Conclusion There are a multitude of research articles that have empirically tested the presence and strength of the momentum effect anomaly and its implication on market efficiency.

In an efficient market, prices fully reflect the biblically available information (Fame 1970). The long lasting presence of this momentum effect as documented in Jadedness and Titian (1993) is a strong indicator that market prices in fact do not reflect all historical information and that stock prices do not follow and walks (Lo and Macmillan 1988). Momentum is an anomaly that is so robust that it appears in international markets and is not Just confined to the US equities market (Roundhouse 1998), (Marshall and Canaan 2005) and (Lie, Lie and Ma 2011).

The fact that it has been proven to be profitable time and time again even adjusting for systematic risk (George and Wang 2004) and behavioral biases (Lie, Lie and Ma 2011) is proof that markets are not efficient. With some anomalies in the past, they tend to disappear after their discovery and subsequent research and publications. Momentum is a long standing anomaly that is widely accepted and researched. With so many research hours devoted to trying to explain this phenomena it is surprising that both institutional and smaller investors are still able to exploit the anomaly using momentum trading strategies (Signing 2010).