Short-term reversal or short-term momentum?

Momentum investors know that in order to exploit the momentum factor it is best to ignore last month’s returns. While stocks that have had positive returns over the last six or twelve months tend to outperform in the coming month or so, stocks that outperformed in the previous month tend to underperform the next. This short-term reversal effect is well known and if you are interested in how big it is, you can download it from Ken French’s database.

Short-term reversal is typically explained with investor overreaction to news that is reversed, once the news has been digested. Stocks thus overreact to positive news and correct afterwards, creating short-term reversals. 

Short-term reversal is why momentum investors typically calculate past price momentum as the performance over the last 12 months minus the performance in the previous month to get better results than by just looking at the return over the previous 12 months.

But what if I told you that there is a group of stocks that does not exhibit short-term reversals? What if I told you that this group of stocks in exhibits short-term momentum, that is stocks that outperformed last month continue to outperform the subsequent month?

In a fascinating paper, Medhat and Schmeling show that while the average stock exhibits short-term reversal, the most highly traded stocks exhibit short-term momentum. Only the stocks with low volume in the previous month show short-term reversal. And the differences are so strong that this short-term momentum effect survives transaction costs implementation lags. And they found it not just in the United States but across 22 developed countries.

Short-term reversal and short-term momentum 

Source: Medhat and Schmeling (2021).

So far, this is just an observation and there is no clear theory why this happens. It seems that short-term momentum exists in high turnover stocks because these tend to be stocks that have many investors with a large variety of opinions trading in the same stocks. And the divergence of opinions creates and underreaction to news and hence short-term momentum as prices digest news more slowly. But that is just a theory. For now, all we have is a fascinating and very large new stock market anomaly that I will be eager to learn more about.