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Reexamining momentum profits: Underreaction or overreaction to firm-specific information?

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Abstract

We design a new measure and find that the predictability of past returns on future returns increases as stocks respond with delay to firm-specific information. Our results suggest that momentum is caused by both investors’ underreaction and overreaction to information. However, underreaction to information seems to be the primary cause, particularly during the more recent period. Our findings are robust for recent explanations of momentum profits and alternative methods for computing our measure. We also find that stocks respond with delay to firm-specific information, partly due to certain firm characteristics, and partly because they escape investor attention due to their low visibility. Our paper extends and refines Jegadeesh and Titman’s (J Financ 56(2):699–720, 2001) finding that momentum profits are consistent with behavioral models’ predictions regarding investors’ overreaction.

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Notes

  1. It is important note that if price of a security and the level of the market index are (not) cointegrated, then the returns of individual securities are (not) predictable by the Eq. 8 even if the market return is white noise. We conducted simulation tests and found that in almost all cases the error correction term has predictability for cointegration series.

  2. Although we estimate λ for each stock every month using past 6 months of daily returns, one may question the constancy of λ parameter due to policy changes or other structural breaks and its impact on using the standard error correction model. In order to ensure that λs generated from our estimations are constant, we conducted Chow test and Elliott–Müller (EM) tests and found that most estimations generate λs that were indeed constant. We also estimated λ for each stock every month using past 6 months of monthly returns for robustness and found results similar to reported here.

  3. In order to reliably infer the results of this section one requires that momentum portfolios’ returns are stationary since we employ error correction model. We investigated this for each of the momentum portfolios in this section by evaluating the time-series plots and more rigorously by Dickey–Fuller unit root tests. Our investigation confirmed that momentum portfolio returns are indeed stationary. We thank an anonymous referee for this suggestion.

  4. The cointegration between the stock and the market index may not be I(1) for some stocks. We found that about 17 % of stocks in our sample are not cointegrated with the market index. There are, on average, 1,709 firms in our sample. So, about 290 firms, on average, are not cointegrated with the market index, which is about 5.8 firms in each portfolio in Table 2. We verified that our results shown in the paper are not affected by the exclusion of the non-cointegrated firms. We thank an anonymous referee for this robustness check.

  5. We do not use the interaction variable between past returns and the capital gains overhang, since Grinblatt and Han (2005) show that, for momentum, past returns is a noisy proxy of capital gains overhang.

  6. To the extent the speed of correction (lamda) suffers from errors in variables problems, the statistical significance of lambda and its interaction with other explanatory variables is understated thus making our results more conservative.

  7. As the referee points out, the more negative SP means the increase of the speed of correction. Similar to findings on momentum strategy in prior studies, M1 (loser) and M10 (winner) have all positive returns and M10 have higher returns than M1. The more negative SP does not necessarily mean that the future return for M10 is negative. It implies that the future return for M10 with the more negative SP is greater than the future return for M10 with the less negative SP because M10 with more negative SP is less underpriced than M10 with less negative SP.

  8. The significant negative sign in Table 4 for the speed of correction variable, though confusing, is due to the negative (positive) relationship between the speed of correction and the loser (winner) portfolios’ returns, as observed in Table 2 in Panel C. We include the speed of correction variable in the regression in order to avoid model misspecification, rather than due to any theoretical considerations.

  9. Contrary to Grinblatt and Han (2005), we find that the past return is statistically significant for explaining future returns in a momentum strategy, even after controlling for capital gains overhang. We conjecture that this happens because we follow returns for the subsequent 6 months, in contrast to the weekly returns focused on in Grinblatt and Han (2005).

  10. Since our sample ends in 2009, we can only examine 60 months post-holding returns for those momentum portfolios formed as of December of 2004.

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Acknowledgments

We are grateful for the valuable suggestions from the Editor, C. F. Lee and an anonymous referee that have significantly improved the quality of the paper. We also thank discussants and participants of Eastern Finance Association meetings of 2011, and Midwest Finance Association meetings of 2011 for their helpful comments.

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Authors and Affiliations

  1. Department of Economics and Finance, College of Business, Louisiana Tech University, Ruston, LA, USA

    Jungshik Hur

  2. Department of Accounting and Finance, College of Business, University of Michigan, Dearborn, Dearborn, MI, USA

    Vivek Singh

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  1. Jungshik Hur
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Correspondence to Vivek Singh.

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Hur, J., Singh, V. Reexamining momentum profits: Underreaction or overreaction to firm-specific information?. Rev Quant Finan Acc 46, 261–289 (2016). https://doi.org/10.1007/s11156-014-0469-x

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