Predictable variation in equity returns might reflect either (1) predictable changes in expected returns or (2) market inefficiency and stock price “overreaction.” These explanations can be distinguished by examining returns over short time intervals since systematic changes in fundamental valuation over intervals like a week should not occur in efficient markets. The evidence suggests that the “winners” and “losers” one week experience sizable return reversals the next week in a way that reflects apparent arbitrage profits which persist after corrections for bid-ask spreads and plausible transactions costs. This probably reflects inefficiency in the market for liquidity around large changes.
Lehmann(1990) shows there are short-term arbitrage opportunities using momentum. The main findings are as follows:
“Winners” and “Losers” experience sizable return reversals the next week.
Table II shows that portfolios of securities that had positive returns (winners) in the prior week typically had negative returns in the next week (-0.35% to -0.55% per week on average), while those with negative returns (losers) in the prior week typically had positive returns in the next week (0.86% to 1.24% per week on average).
“Contrarian strategies” (buying past losers and selling past winners) generate abnormal returns of over 2% per month.
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.
Overall, Lehmann (1990) believes that investors’ cognitive bias lead to market inefficiency and short-term return reversals.
Similar with Lehmann (1990), Jegadeesh (1990) also demonstrates the short-term reversal effect (monthly horizon).
This finding (and Jegadeesh 1990) is why academics generally use 2-12 momentum (last 12-month returns, excluding the previous month) when examining intermediate-term momentum (last 12-month returns) effect on stock prices.
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.
Performance figures contained herein are hypothetical, unaudited and prepared by Alpha Architect, LLC; hypothetical results are intended for illustrative purposes only. Past performance is not indicative of future results, which may vary. There is a risk of substantial loss associated with trading stocks, commodities, futures, options and other financial instruments. Full disclosures here.