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JOURNAL OF INVESTMENT MANAGEMENT, Vol. 4, No. 1, (2006), pp. 1–20
© JOIM 2006
Kalok Chana,∗ and Hung Wan Kotb
a. Department of Finance, Hong Kong University of Science and Technology, Clear Water Bay, Hong Kong.
b. Department of Finance, University of Waikato, Private Bag 3105, Hamilton, New Zealand.
∗Corresponding author. Tel.: 852-2358-7680; fax: 852-2358-1749; e-mail: kachan@ust.hk
This paper investigates whether investors can exploit the contrarian cycle to improve the profitability of momentum strategies. We conjecture that the momentum strategies implemented in the early stage of price reversal (MSES) are more profitable than those implemented in the late stage of price reversal (MSLS). Our empirical results show that while MSES records significant positive returns, the profits from MSLS are not significant. There is a continuation of momentum profits in MSES up to 60 months, but not in MSLS. The overall evidence indicates that we can improve the profits of momentum strategies if we also consider past long-term performance.
Introduction
The success of short-term price momentum is widely documented in the literature. Jegadeesh and Titman (1993, 2001a), Chan et al. (1996, 2000), Rouwenhorst (1998), and Grundy and Martin (2001) show that there are price continuations at horizons of 3–12 months, and that momentum strategies of buying past winners and selling past losers are profitable when implemented according to these time horizons. At the same time, many studies indicate that price tends to be reversed over the long term. DeBondt and Thaler (1985, 1987) and Chopra, Lakonishok and Ritter (1992) show that there are price reversals at horizons of around 3–5 years, and that contrarian strategies of buying past losers and selling past winners are profitable when implemented according to such horizons.
Despite the coexistence of short-term price momentum and long-term price reversals, there has not been much joint empirical analysis of the two effects. The objective of this paper is to investigate whether an investor could take advantage of the contrarian cycle to improve the profitability of the momentum strategies. The rationale behind our investigation is that the occurrence of price reversal signals a turning point in the market so that the price momentum will be accelerated. The triggering of a price reversal indicates a substantial mispricing, and hence draws the market attention so that the price momentum effect is stronger during the early stage of price reversal.
The market attention created during the early stage of price reversal is similar to the phenomenon described by Lee and Swaminathan (2000), who show that trading volume is important in affecting the profitability of momentum strategies. Trading volume is another indicator of the level of market attention. Lee and Swaminathan demonstrate that past trading volume predicts both the magnitude and the persistence of future price momentum, with the price momentum of low-volume stocks being smaller than that of large-volume stocks.
In the empirical analysis we therefore examine whether momentum strategies implemented in the early stage of a price reversal (MSES) yield the highest profitability. In particular, we distinguish between MSES and momentum strategies implemented in the late stage of a price reversal (MSLS). First, we follow traditional momentum strategies by sorting the stocks into winners and losers based on past short-term performance. Second, within the short-term winner portfolio and short-term loser portfolio, we further sort stocks into long-term winners and long-term losers according to long-term performance in the past. To implement MSES, we buy stocks that are short-term winners but long- term losers, and sell stocks that are short-term losers but long-term winners. To implement MSLS, we buy stocks that are both short-term and long-term winners, and sell stocks that are both short-term and long-term losers. As there is no theoretical basis or empirical literature that predicts the MSLS to be successful, we conjecture that the price momentum for MSES is bigger than for MSLS, so that MSES is more profitable.
Our empirical work is different in several ways from previous studies that investigate the joint interaction of momentum strategies and contrarian strategies. It is different from the work of Jegadeesh and Titman (2001a), who show how the profits of momentum-sorted portfolios are reversed when the portfolios enter the contrarian cycle. Instead, we explore how the profits of momentum–sorted portfolios are different when they are formed at the early stage versus the late stage of the contrarian cycle. Balvers and Wu (2002) also construct an indicator based on the mean reversion and momentum effects. By applying the analysis to 18 developed equity markets on a monthly basis, they find that combined momentum–contrarian strategies outperform both pure momentum and pure mean reversion strategies. This is different from our work as our analysis is based on individual securities instead of stock market indices.
Our results show that the momentum profits could be enhanced with the consideration of the contrarian cycle—while returns of MSES are significantly positive, the returns of MSLS are insignificantly different from zero. Our empirical results are insensitive to the choice of holding period and sample period. Furthermore, unlike Jegadeesh and Titman (2001a), who demonstrate that the momentum profits will be reversed after 12 months, we show that the momentum profits of MSES continue to increase in the 60-month holding period. Therefore, the price continuation is much stronger for stocks that are in the early stage of the contrarian cycle. Not surprisingly, since the past long-term performance affects the book-to-market ratio, the long-term winner (loser) stocks have lower (higher) book-to-market ratios. Based on Fama and French’s three-factor model, the long-term winners (losers) have negative (positive) factor loadings on the book-to-market factor. Therefore, another way of capturing momentum returns at the early stage of the contrarian cycle is to buy short-term win- ners that have high book-to-market ratios and sell short-term losers that have low book-to-market ratios.
The remainder of this paper is organized as follows. Section 1 reviews the previous work on momentum strategies and presents the methodologies for investigating the joint effects of price momentum and price reversal. Section 2 presents empirical results. Section 3 provides long-term performance and robustness checks. Section 4 concludes the paper.
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