What’s momentum, anyway?
Price momentum is one of the strongest anomalies in stock markets. We know momentum strategies create excess returns over the market and these excess returns are similar in size or even larger than the value or the small cap premium. Momentum effects have also been documented across asset classes and it can be shown that momentum in one asset class creates momentum in another.
Given the strength and omnipresence of the momentum factor it might surprise you to learn that we still don’t really know what creates momentum and why it persists and isn’t arbitraged away? After all, in academic speak, the momentum effect is a violation of the weak form of the efficient market hypothesis. Mind you there are a number of possible explanations that can explain the momentum effect:
Investor overconfidence: If investors are overly confident in their own abilities, they tend to attribute profitable investments to their skill and losses to bad luck. Over time, this leads investors to overweight their own information and views vs. other information and creates a bias to invest in the same asset again and again. Aggregated over millions of investors this creates a momentum effect as investors flock to the same stocks and thus provide more and more fuel to the fire.
Slow diffusion of information: The efficient market hypothesis assumes that all investors use all available fundamental information to form an opinion about stocks or other assets. But if some investors only use price data and a limited set of fundamental information, then new fundamental information spreads across the market only slowly creating momentum effects as more and more investors catch up with newly available fundamental data.
Anchoring: I have recently written how the 52-week high of a stock changes the market dynamic. If investors use the 52-week high and other anchors as psychological markers, then they will perceive stocks that are far below their anchor as “cheap” while stocks that are close to this anchor are perceived as “expensive”. This triggers a rush into stocks perceived as “cheap” and creates a momentum effect for these stocks.
Limited attention: Because there is way too much information available to all of us, we limit our attention only to the biggest outliers or the most spectacular bits of information like a large earnings miss. Small, seemingly irrelevant bits of information that is disclosed in a steady stream tends to be ignored. This creates underreaction to these stocks and a momentum effect as information is only gradually incorporated in the share price.
Time varying growth option: While the previous explanations are all psychological in nature, one can also create a “rational” explanation for the momentum effect by modelling a stock as a safe asset with a call option on future growth on top. As growth options vary over time, the varying value of the call option will create price momentum in the stock.
Narasimhan Jegadeesh, one half of the duo that popularised the momentum effect, teamed up with Amit Goyal and Avanidhar Subrahmanyam to stage a horse race between these different explanations and try to identify which one explains the momentum effect best.
And the winner is, drum roll: Limited attention. According to their study the limited attention hypothesis explains out of sample momentum effects better than any of the other explanations. This has some interesting applications. For one, there is indeed a role to play for fundamental equity analysts. Cynics say that equity analysts and strategists are useless because their forecasts are hardly ever accurate. That is true, but the true benefit of analysts in this context may not be their forecasts but their ability to speed up the dissemination of information across the market. The more investors use fundamental analysis, the less dominant the momentum effect should become because information is aggregated and incorporated in prices more rapidly. But with the rise of index funds and ETFs, fundamental analysis has become less popular over that two decades. It may just be coincidence, but it certainly is interesting that during this time the momentum effect has become stronger.