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Firm ratings, momentum strategies, and crises: evidence from the US and Taiwanese stock markets

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Abstract

This paper investigates whether there is a link between momentum profitability and firm ratings. We follow traditional and practical (non-) investment-grade classifications to divide into three rating groups, high, median, and non investment-grade group (HIG, MIG, and NIG) since firm ratings express risk in relative rank order to contain valuable information. This study considers the US and Taiwanese stock markets. We find that firm ratings momentum strategies can even earn positive profits, larger than naïve momentum, supporting that firm ratings can be used to strengthen naive momentum effects. By comparisons, the US firm ratings momentum with NIG produces larger profits than HIG but opposite in direction and V-shaped pattern in Taiwan. With an examination of crises on firm ratings momentum, we find that firm ratings momentum indeed helps increase the payoff during (non-)crises although firm ratings momentum profits should be strong following non-crises states and weak following crises states. However, firm ratings momentum profits partially result from the predictability of business cycle, calendar months, and information asymmetries. Our results highlight the critical importance of using firm ratings screens in empirical momentum studies.

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Notes

  1. Ammann et al. (2011a) show a evidence for a momentum effect in the Japanese stock market, at least for internationally traded large-cap stocks.

  2. Credit ratings derive their value primarily from two institutional features. The first is the monitoring role of credit rating agencies, which is most apparent in their credit watch procedures. The second is the role credit ratings play in the investment decisions of institutional investors.

  3. Among high credit quality firms the smaller difference between winners and losers is expected to be found but the larger difference between winners and losers among low credit quality firms is anticipated because prior studies document a negative cross-sectional correlation between credit risk and future stock returns.

  4. For instance, in November 2010, BBVA Research reports that Taiwan is one of nine nations and its expected incremental GDP in the next 10 years to be larger than the average of the G7 economies.

  5. Taiwan’s real growth in GDP has averaged about 8 % during the past three decades. Exports have provided the primary impetus for industrialization. The trade surplus is substantial, and foreign reserves are the world’s fifth largest.

  6. The Taiwan Stock Exchange Capitalization Weighted Stock Index (TAIEX) is the most widely quoted of all Taiwan Stock Exchange Corporation (TWSE) indices. TAIEX covers all of the listed stocks excluding preferred stocks, full-delivery stocks and newly listed stocks, which are listed for less than one calendar month.

  7. The corporate rating methodology encompasses two basic components: business risk analysis and financial risk analysis. It is critical to understand that the rating analysis is not limited to an examination of various financial measures. In addition, it is in detail to see the website on TEJ that https://doi.org/www.tej.com.tw/webtej/doc/crwatch.htm.

  8. Information uncertainty is the degree of ambiguity about firm fundamentals. High information uncertainty firms can be associated with higher information acquisition costs and less reliable estimates of their value.

  9. As unreported in this study, we present the mean and standard deviation for an alternative leverage measure defined as the ratio of book value of debt to the book value of equity, with the mean of 1.9620 and the standard deviation of 1.6743 in the US stock market and the mean of 1.2616 and the standard deviation of 3.1068 in Taiwanese stock market. We have similar arguments of Taiwanese stock market with greater information uncertainty for two leverage measures.

  10. As unreported in this study, momentum profits are significant and positive (1.42 % per month) for prior winners and insignificant and positive (0.23 % per month) for prior losers in the US stock market. On the other hand, momentum profits are insignificantly negative return (\(-\)0.26 % per month) for prior winners and significantly negative return (\(-\)1.08 % per month) for prior losers in the Taiwanese stock market.

  11. In the US stock market, payoffs to winners in MIG and NIG are 1.30 % per month and 1.56 % per month whereas those to losers are \(-\)0.25 % per month and \(-\)0.52 % per month. In the Taiwanese stock market, payoffs to winners and losers in HIG are 0.07 % per month and \(-\)0.92 % per month.

  12. We conduct the switching regression proposed by Tsay (1989) and check the data for structural breaks. We find the switching dates on 2007 subprime crisis are June 2007 in the US and July 2007 in Taiwan, respectively.

  13. In their study, from 1929 to 1995, the average monthly momentum profit following positive market returns is 0.93 %, whereas the average profit following negative market returns is \(-\)0.37 %.

  14. In the study by Daniel et al. (1998), they assume that investors are overconfident about their private information and overreact to it. If overconfidence is in fact higher following market increases, then the overreactions will be stronger following these up markets generating greater momentum in the short-run. Hong and Stein (1999) employ two types of investors: “newswatchers” and “momentum traders.” The newswatchers rely exclusively on their private information; momentum traders rely exclusively on the information in past price changes. Their model is based on initial underreaction to information and subsequent overreaction, which eventually leads to price reversal in the long-run.

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Acknowledgments

We thank the editor of FMPM and anonymous referees for their extremely helpful comments and suggestions on the original draft.

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  1. Department of Finance, Chaoyang University of Technology, Wufong District, Taichung, 41349, Taiwan

    Nicholas Rueilin Lee

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Rueilin Lee, N. Firm ratings, momentum strategies, and crises: evidence from the US and Taiwanese stock markets. Financ Mark Portf Manag 26, 449–468 (2012). https://doi.org/10.1007/s11408-012-0195-0

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