At Last, the Momentum Investing Puzzle Solved?

The simplest explanation — “I can’t believe you know something I don’t” — may trump all the rest

UCLA Anderson’s Avanidhar Subrahmanyam has spent a good chunk of his career researching one of Wall Street’s biggest mysteries: momentum, which is the tendency of the stock market’s recent winners to remain winners in the near term and, likewise, for recent losers to remain losers for a while.

Momentum investing’s strong record of success as a strategy has vexed academics and market professionals alike because it defies one of modern finance’s key tenets: that markets are efficient. In part, efficiency means that no trading pattern should persistently beat the market because as soon as investors learn it, stock prices should quickly adjust to remove the easy reward potential.

Decades of research have sought to explain the momentum anomaly in the context of the efficient market theory. Now, in a working paper, Nanyang Technological University’s (Singapore) Jiang Luo, Subrahmanyam and University of Texas’ Sheridan Titman suggest that much of that research amounted to overthinking. Instead, they propose an explanation rooted in basic human nature. Many investors, they say, simply refuse to believe that their competition in the market might know more than they do. In the case of rising stocks, that skepticism acts as a brake, slowing their advance but also extending it.

Luo, Subrahmanyam and Titman refer to their new model of momentum as “parsimonious.” Or, as Subrahmanyam said in an interview, they believe that momentum is driven by the most “minimal and reasonable assumptions about human behavior.”

It was in 1993 that Titman, then at UCLA, and his colleague Narasimhan Jegadeesh, first documented how, from 1965 to 1989, strategies of buying recent stock winners and selling recent losers generated significantly higher near-term returns than the U.S. market overall.

They set down the basic time frame for momentum-investing success as a 3-to-12-month window on either side. So a stock’s relative performance (up or down, versus the market) over the previous three to 12 months typically predicted its relative performance for the following three to 12 months. The paper focused in depth on a portfolio that selected stocks based on their previous six-month returns, held them for six months, and then sold. That strategy produced an extra return of about 1% per month above what would have been expected, Jegadeesh and Titman found. Over time, that bonus over the market return adds up to a substantial premium.

Since that pioneering study, other researchers have documented how momentum trading strategies (also known as “relative strength” trading) have been profitable not just on Wall Street but in foreign stock markets, bonds, currencies and commodities. Of course, the strategy isn’t foolproof. It doesn’t work every time, and is particularly dangerous to pursue in bear markets (as in 2008). But its long-term success has been undeniable.

Could Subrahmanyam and his colleagues finally have the best answer as to why? “We believe so,” Subrahmanyam said in an interview. But as academics, he added, “We cannot take a definitive position.” It’s now for other researchers to try to prove them wrong — or right.

To reach their conclusion, Luo, Subrahmanyam and Titman designed a model to simulate different investors receiving pertinent information about a stock at different times, as occurs in real life. But instead of later-informed investors trusting that earlier-informed investors have learned something of value, many of the later-informed are skeptical. They “assume that those with valid information have learned little of consequence,“ the study says. At the same time, the later-informed investors tend to be overconfident in their own information about the stock.

Essentially, later-informed investors believe that the earlier-informed investors are more uncertain about a stock than they actually are, Subrahmanyam said in the interview. Here, it gets complicated. That belief leads the later-informed skeptics to sell while the earlier-informed investors are buying. “Basically, the skeptics don’t allow the price to move much,” Subrahmanyam said. But if certain positive market signals around the stock persist, the net effect of the skeptics’ selling is to prolong the stock’s rally, in turn attracting more investors. Hence, momentum.

While the authors’ model relies on calculations such as a stock’s expected volatility, Subrahmanyam said their theory also is backed by foundational research into the human mindset. He cites behavioral-economics expert Colin Camerer’s work at Caltech on “competition neglect.” Camerer and co-author Dan Lovallo of Wharton describe a situation in which “entrants into a business not only believe that they will earn abnormally positive profits but also that their opponents will incur losses in aggregate,” Subrahmanyam said. “This is basically our assumption in the context of financial markets [as well].”

Luo, Subrahmanyam and Titman suggest that the flip side of momentum — the eventual reversal of some or all of a stock’s momentum-period gains — is caused by investor skepticism. “While skepticism causes under-reaction in earlier [trading], it also causes prices to react [later] to stale information and subsequently reverse,” the authors write.

Subrahmanyam provided this explanation in the interview: “Suppose Netflix’s growth in accounts is lower than expected, and some traders already know this. The stock price moves down a bit but not as much because skeptics don’t believe the information is valid. Later, when this information becomes known to more people, the skeptics do react” to what is then stale information. “The idea is that after the early- and late-informed have both received their info, the price overreacts to both their signals and, subsequently, reverses.”

If Luo, Subrahmanyam and Titman have at last identified the primary force behind momentum and reversals, the question becomes whether their findings could change the momentum game.

Ultimately, Subrahmanyam said, “Momentum’s existence is a matter of the arbitrage capital devoted to it” — that is, the size of the bets investors are willing to make when they’re confident they see something in an asset’s price that others are missing.

To put it another way, “The more the capital that arbitrages human failings, the less the strength of momentum,” Subrahmanyam said.