Maximilian Brodin and Øyvind Abusdal
Supervisor: Per Östberg
Master Thesis in Financial Economics
NORGES HANDELSHØYSKOLE
This thesis was written as a part of the Master of Science in Economics and Business
Administration program - Major in Financial Economics.
Abstract
This paper documents the maximum theoretical excess return on the market to 3.8% monthly from momentum trading in Norway and estimates the economical excess return to be marginally higher than 1% per month when accounting for microstructure influences. We find that the excess returns of various momentum strategies are not explained by systematic risk or exposure to other factors such as size or book-to-market value. We uncover a positive correlation between types of investor and the degree of momentum in the market. Studying business cycles has provided evidence of reversals following bust periods which are in-line with behavioral theories of overreaction.
Introduction
Can historic observations of a publically traded company’s performance be used to predict their future performance? That question is the essence of this paper and there are several ways of answering it; for example one could look at various performance measures such as earnings or stock prices. We have chosen to work with the latter, or more specifically, we are examining whether there is a tendency for stock returns to trend in the same direction and thereby establish whether there is momentum in the stock market. We test whether or not it is possible to earn abnormal returns on the Oslo Stock Exchange by forming winner and loser portfolios on the basis of past stock returns.
Empirical evidence from vast research in several markets document this anomaly known as momentum. A recent London Business School research with 108 years of data covering about 85% of the world equity market capitalization concluded that “The momentum effect, both in the UK and globally, has been pervasive and persistent” (Dimson, Marsh and Staunton, 2008). Rouwenhorst (1998) finds in a study of 12 European countries including Norway in the period from 1978 to 1996 that an internationally diversified momentum portfolio earns about 1% excess return on the market per month.
Much of the research on momentum has been dedicated to trying to explain the excess return earned from following such a strategy by adjusting for various factors such as the size effect, book-to-market ratios and market risk. During the last 25 years, attempting to explain investor behavior has also gained a lot of attention in trying to explain the momentum effect.
Jegadeesh and Titman (1993) find that excess returns from following momentum strategies are not due to systematic risk or to delayed stock price reactions to common factors such as the January effect. Jegadeesh and Titman (2001) also present evidence which supports the prediction of behavioral finance models that suggest that the momentum effect is due to overreactions in the market. Grinblatt and Keloharju (2000) analyze different investor groups and find that the degree of momentum behavior seems to be strongly correlated to the degree of sophistication of the investor types.
Kloster-Jensen (2005) finds that a momentum strategy on the Oslo Stock Exchange (OSE) yields significant positive returns, but this is due to a large extent by compensation for taking on added systematic risk. Hence, he concluded that there is no momentum effect in the Norwegian market. Conversely, Myklebust (2007) examines sixteen different time-strategies for momentum trading on the Oslo Stock Exchange and finds that all strategies yielded positive excess returns, which could not be explained by market risk or the size effect.
Up until now OSE momentum research has been limited to using data samples of stocks that have been traded during the whole sample periods. This has narrowed the data sets to about 70 stocks which can be compared to the actual number of almost 600 stocks that have been listed during the last eleven years, which is the time period we examine. Our approach is different; and by analyzing a dataset of 598 stocks we can provide evidence of the maximum theoretical excess return that can be earned from a momentum strategy on the OSE. This is accomplished by 16 different time-strategies that are comprised of a forming period (ranking period of the stocks) and a holding period. These strategies are evaluated by accounting for risk exposure, or more precisely systematic risk (CAPM) and the size effect using a two- factor regression model.
The total data set is then screened based on a set of rules that provides us with 123 stocks suitable for evaluating the maximum economic excess return that can be earned (i.e. a dataset that gives us the opportunity to test the momentum strategy when accounting for microstructure influences such as transaction costs). In this part of the study we explore one time-strategy, which we call “the best strategy portfolio”.
As with many of our predecessors, we attempt to explain excess return by accounting for various factors; here we expand the model to include a third factor: book-to market ratio, using the Fama and French three factor model.
We also probe areas that have not been explored in earlier momentum research for the Norwegian stock market. We test for seasonality by deducting and secluding January returns. Through descriptive studies of the dataset we highlight any under or over-representation among sectors in the momentum portfolios and provide intuitive explanations to why some sectors are biased towards either the loser portfolio or the winner portfolio. Moreover, we examine the momentum returns throughout business cycles to identify any variations in good times and bad times.
Finally, we expand the discussion of momentum explanations by building on Grinblatt and Keloharju’s 2000 research on the behavior of different investor types. We find that there has been a development over time in the type of investors that are active on the Oslo Stock Exchange and we examine whether this could be correlated to an increase (or a decrease) in the momentum effect over time.
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