Momentum in Imperial Russia Tuesday, 20 October, 2015

#14 - Momentum Effect in Stocks

Authors: Goetzmann, Huang

Title: Momentum in Imperial Russia

Link: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2663482

Abstract:

Some of the leading theories of momentum have different empirical predictions about its profitability conditional on market composition and structure. The overconfidence explanation provided by Daniel, Hirshleifer, and Subrahmanyam (1998), for example, predicts lower momentum profits in markets with more sophisticated investors. The information-based theory of Hong and Stein (1999) predicts lower momentum profits in markets with lower informational frictions. The institutional theory of Vayanos and Woolley (2013) predicts lower momentum profits in markets with less agency. In this paper we use a dataset from a major 19th century equity market to test these predictions. Over this period there was no evidence of delegated management in Imperial Russia. A regulatory change in 1893 made speculating on the St. Petersburg stock market more accessible to small investors. We find a momentum effect that is similar in magnitude to those in modern markets, and stronger during the post-1893 period than during the pre-1893 period, consistent with the overconfidence theory of momentum.

Notable quotations from the academic research paper:

"Momentum strategies, also known as relative strength strategies, are a class of long-short trading strategies that buy past winners and sell past losers. Jegadeesh and Titman (1993) first document the pro fitability of momentum strategies in a sample of U.S. stocks during the period from 1965 to 1989. Many other studies extend this initial finding by documenting momentum pro fitability in the post-1989 period, in equity markets outside of the U.S., and in other asset classes While there is an abundance of empirical evidence for momentum, the debate on its underlying mechanism remains unsettled. For instance, Daniel, Hirshleifer, and Subrahmanyam (1998) propose a model in which investor overcon dence about the precision of private information generates the momentum e ffect. On the other hand, in Hong and Stein's (1999) model, the interaction of boundedly rational agents and the slow di ffusion of information generate initial underreaction and subsequent overreaction. More recently, Lou (2012) and Vayanos and Woolley (2013) propose explanations of momentum driven by flows into and between institutional money managers.

While these theories all generate the momentum eff ect, they have di fferent predictions about momentum pro fitability conditional of market composition and structure. Tests of these predictions require signi ficant variation for identification. In this paper we use a comprehensive dataset of monthly stock returns from the St. Petersburg Stock Exchange in the 19th and early 20th centuries to test these predictions. The St. Petersburg Stock Exchange provides an ideal setting for investigating momentum because: 1) it is, as yet, an untouched sample for finance researchers; 2) there was no evidence of a delegated management structure in the Russian Empire over this period; and 3) a regulatory change in 1893 substantially reduced the costs of speculative trading for less sophisticated investors. The institutional theory predicts a muted momentum eff ect in such a market as the institutions that the theory relies on to generate momentum were absent. The overcon dence theory predicts lower momentum profi ts during the pre-1893 period than during the post-1893 period, because in the later period there was more market participation by those who are more susceptible to being overconfi dent. In contrast, the information di ffusion theory predicts higher momentum profi ts during the pre-1893 period, because market participation was narrower and information flow was slower.

Our results are consistent with the investor overcon dence theory. Despite the absence of a delegated management structure in our setting, we find that past medium-term winners outperform past medium-term losers by as much as 74 basis points per month, which is similar in magnitude to momentum pro ts in modern markets. Exposure to the market factor cannot explain this outperformance. In addition, we fi nd that the momentum eff ect is small and insigni ficant during the pre-1893 period, but large and highly signi ficant during the post-1893 period. A placebo test using momentum returns from the London Stock Exchange shows that the same empirical regularity is not observed in a market that did not undergo a similar regulatory change.

Daniel and Moskowitz (2013) document that the momentum trade occasionally experiences large crashes. This suggests that, whatever the mechanism, momentum profi ts could compensate for an infrequently occurring risk factor. Based on this idea, they propose a method to manage this extreme left-tail risk.Interestingly, in our Russian sample extending more than 40 years, we find that while momentum returns are somewhat negatively skewed, extraordinary crashes like those that occurred in the U.S. are absent."


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Carry trade strategies explained by structure of international trade Thursday, 15 October, 2015

#5 - FX Carry Trade

Authors: Ready, Roussanov, Ward

Title: Commodity Trade and the Carry Trade: A Tale of Two Countries

Link: http://jacobslevycenter.wharton.upenn.edu/wp-content/uploads/2015/05/Commodity-Trade-and-the-Carry-Trade-4.3.15.pdf

Abstract:

Persistent differences in interest rates across countries account for much of the profitability of currency carry trade strategies.  The high-interest rate "investment" currencies tend to be "commodity currencies,"  while low interest rate "funding" currencies tend to belong to countries that export finished goods and import most of their commodities.  We develop a general equilibrium model of international trade and currency pricing in which countries have an advantage in producing either basic input goods or final consumable goods. The model predicts that commodity-producing countries are insulated from global productivity shocks through a combination of trade frictions and domestic production, which forces the final goods producers to absorb the shocks.  As a result, the commodity country currency is risky as it tends to depreciate in bad times, yet has higher interest rates on average due to lower precautionary demand, compared to the final-good producer.  The carry trade risk premium increases in the degree of specialization, and the real exchange rate tracks relative technological productivity of the two countries.  The model's predictions are strongly supported in the data.

Notable quotations from the academic research paper:

"A currency carry trade is a strategy that goes long high interest rate currencies and short low interest rate currencies. A typical carry trade involves buying the Australian dollar, which for much of the last three decades earned a high interest rate, and funding the position with borrowing in the Japanese yen, thus paying an extremely low rate on the short leg. Such a strategy earns positive expected returns on average, and exhibits high Sharpe ratios despite its substantial volatility.  In the absence of arbitrage this implies that the marginal utility of an investor whose consumption basket is denominated in yen is more volatile than that of an Australian consumer. Are there fundamental economic di erences between countries that could give rise to such a heterogeneity in risk?

One  source  of  di erences  across  countries  is  the  composition  of  their  trade. Countries that specialize in exporting basic commodities, such as Australia or New Zealand, tend to have high interest rates.  Conversely, countries that import most of the basic input goods and  export  fi nished  consumption  goods,  such  as  Japan  or  Switzerland,  have  low  interest rates on average.  These diff erences in interest rates do not translate into the depreciation of
"commodity currencies" on average; rather, they constitute positive average returns, giving rise  to  a  carry  trade-type  strategy. In  this  paper  we  develop  a  theoretical  model  of  this phenomenon, document that this empirical pattern is systematic and robust over the recent time period, and provide additional evidence in support of the model's predictions for the dynamics of carry trade strategies.

We show that the diff erences in average interest rates and risk exposures between countries  that  are  net  importers  of  basic  commodities  and  commodity-exporting  countries can be explained by appealing to a natural economic mechanism:  trade costs.

We model trade costs by considering a simple model of the shipping industry.  At any time the cost of transporting  a  unit  of  good  from  one  country  to  the  other  depends  on  the  aggregate  shipping capacity available.  While the capacity of the shipping sector adjusts over time to match the demand for transporting  goods between countries,  it  does so slowly,  due to  gestation  lags in the shipbuilding industry.  In order to capture this intuition we assume marginal costs of shipping an extra unit of good is increasing - i.e., trade costs in our model are convex.  Convex shipping costs imply that the sensitivity of the commodity country to world productivity shocks is lower than that of the country that specializes in producing the final consumption good, simply because it is costlier to deliver an extra unit of the consumption good to the commodity  country  in  good  times,  but  cheaper  in  bad  times.   Therefore,  under  complete financial markets, the commodity country's consumption is smoother than it would be in the absence of trade frictions, and, conversely, the commodity importer's consumption is riskier. Since the commodity country faces less consumption risk, it has a lower precautionary saving demand and, consequently, a higher interest rate on average, compared to the country producing manufactured goods.  Since the commodity currency is risky - it depreciates in bad times - it commands a risk premium.  Therefore, the interest rate di fferential is not off set on average by exchange rate movements, giving rise to a carry trade.

We show empirically that sorting currencies into portfolios based on net exports of fi nished (manufactured) goods or basic commodities generates a substantial spread in average excess returns, which subsumes the unconditional (but not conditional) carry trade documented by Lustig,  Roussanov,  and  Verdelhan  (2011).   Further,  we  show  that  aggregate  consumption of  commodity  countries  is  less  risky  than  that  of  finished  goods  producers,  as  our  model predicts"


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Optimization of Equity Momentum Wednesday, 7 October, 2015

#14 - Momentum Effect in Stocks

Authors: van Oord

Title: Optimization of Equity Momentum: (How) Does it Work?

Link: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2653680
 

Abstract:

Standard mean-variance optimized momentum outperforms the traditional equally weighted momentum strategy if the expected return vector used reflects momentum's top and bottom only characteristic. This top and bottom only characteristic is the phenomenon that only the stocks in the top decile of momentum's ranking outperform and that only stocks in the bottom decile underperform, while all stocks in the intermediate deciles of the ranking have similar performance. If the optimization does not take this phenomenon into account the portfolio is also long the deciles 2 to 5 and short the deciles 6 to 9, while all these positions thus do not add anything to the return of the strategy. A new simplified bootstrapping methodology shows that the Sharpe-ratio of 52.8 percent of the optimized portfolio is significantly higher (p-value of 0.006) than the Sharpe-ratio of 29.3 percent for traditional equally weighted momentum. The optimized portfolio also exhibit less time-varying equity risk factor return exposures than traditional momentum and as such have more stable returns over the business cycle and have smaller drawdowns.

Notable quotations from the academic research paper:

"The traditional momentum strategy ranks stocks on their recent 3 to 12 months average returns, skips one month to overcome short-term return reversals and then buys the stocks in the top decile of the ranking and short-sells the stocks in the bottom decile of this ranking. Jegadeesh and Titman (1993) show that this traditional momentum strategy has a signi cant positive average return. Using standard mean-variance optimization with these recent average stock returns as input for the expected returns results in a signi cantly higher Sharpe-ratio than the traditional momentum strategy if the expected returns reflect momentum's top and bottom only characteristic.

We show that the momentum is a top and bottom only strategy. Given momentum's signi cant outperformance of the top decile over the bottom decile of its ranking on the stocks' recent performance one would expect that stocks in the second decile would also outperform stocks in the ninth decile. This is, however, not the case: all stocks in the second to ninth decile have similar performance. When using the recent stocks' performances as expected returns
in the optimization thus results in long positions in the second to fth decile and short positions in the sixth to ninth deciles. These long-short positions do not add to the performance as they have similar returns. In fact, these positions decrease momentum's performance as they reduce the weights in the top and bottom decile that do outperfom each other and do add to the performance."


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How general market conditions affect industry/sector momentum ? Thursday, 1 October, 2015

#3 - Sector Momentum - Rotational System

Authors: Huhn

Title: Industry Momentum: The Role of Time-Varying Factor Exposures and Market Conditions

Link: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2650378

Abstract:

This paper focuses on momentum strategies based on recent and intermediate past returns of U.S. industry portfolios. Our empirical analysis shows that strategies based on intermediate past returns yield higher mean returns. Moreover, strategies involving both return specifications exhibit time-varying factor exposures, especially the Fama and French (2015) five-factor model. After risk-adjusting for these dynamic exposures, the profitability of industry momentum strategies diminishes and becomes insignificant for strategies based on recent past returns. However, most strategies built on intermediate past returns remain profitable and highly significant. Further analyses reveal that industry momentum strategies are disrupted by periods of strong negative risk-adjusted returns. These so-called momentum crashes seem to be driven by specific market conditions. We find that industry momentum strategies are related to market states and to the business cycle. However, there is no clear evidence that industry momentum can be linked to market volatility or sentiment.

Notable quotations from the academic research paper:

"Our empirical results indicate that momentum strategies based on industry portfolios are profitable within the U.S. Moreover, in line with Novy-Marx (2012), strategies based on intermediate past returns from months twelve to seven exhibit higher returns than strategies based on recent past returns from months six to two prior to portfolio formation. However, when using alternative formation periods for intermediate past returns, our results do not support the hypothesis of momentum being an “echo” in returns.

Our paper seeks to determine whether industry momentum strategies based on recent and intermediate past returns exhibit time-varying factor exposures in the U.S. We therefore apply different factor models and examine which model best explains industry momentum returns. Our results indicate that for both return specifications, industry momentum strategies exhibit time-varying factor exposures, especially using the FF (2015) five-factor model. Hedging these time-varying factor exposures diminishes the outperformance of industry momentum strategies.

To the best of our knowledge, no study so far has analyzed the relation between market conditions and industry momentum strategies based on both recent and intermediate past returns. Giving additional scrutiny to this research area, we examine whether industry momentum strategies are also disrupted by periods of strong negative returns. Our empirical analyses reveal that industry momentum strategies based on both return specifications experience periods with large negative risk-adjusted returns. Moreover, these so-called momentum crashes seem to be driven by specific market conditions. We find that industry momentum strategies are related to market states and are thus only profitable following “UP”-markets. We do not find positive and significant risk-adjusted returns following “DOWN”-markets, regardless of market transitions. These results support behavioral explanations as the source of the profitability of industry momentum strategies. Dividing both recessions and expansions into two halves, our results indicate that most strategies exhibit positive and significant risk-adjusted returns only during the second half of an expansion. Finally, our findings do not support the notion that industry momentum strategies are related to market volatility or investor sentiment."


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New academic paper analyses #38 - Accrual Anomaly Tuesday, 22 September, 2015

#38 - Accrual Anomaly

Authors: Patatoukas

Title: Asymmetrically Timely Loss Recognition and the Accrual Anomaly

Link: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2653979

Abstract:

Conditionally conservative accounting practices mandate the more timely recognition of losses relative to gains through transitory negative accrual items. A direct implication of asymmetrically timely loss recognition is asymmetry in the persistence of accruals depending on whether the firm experiences a gain or a loss in the current year: accruals should be less persistent for loss years relative to profit years. If investors naively fixate on total earnings, however, conditional conservatism would imply that investors will tend to overestimate the persistence of accruals especially in loss years. Consistent with naïve earnings fixation, I find that Sloan’s (1996) accrual anomaly, i.e., the negative association between accruals and future abnormal stock returns, is more pronounced for loss firms relative to profit firms. The evidence is relevant for understanding the origins of the accrual anomaly and highlights that inferences with respect to the pricing of accruals can be affected by pooling loss firms with profit firms.

Notable quotations from the academic research paper:

"Separating firms based on the sign of reported earnings, I find that although the accrual anomaly extends across profit and loss firms, it appears to be stronger for loss firms. The average hedge return from buying/selling low/high accrual loss firms is 16.99 percent, while the hedge return from buying/selling low/high accrual profit firms is 5.82 percent. Evidence of accrual mispricing further increases when I separate loss firms experiencing negative contemporaneous abnormal returns (roughly 72 percent of all loss firms), with the hedge return from buying/selling low/high accrual loss firms rising to 21.77 percent.

Overall, the evidence suggests that the subsample of loss firms is more susceptible to accruals mispricing, which is consistent with the prediction that investors naively fixate on total earnings and, therefore, tend to overestimate the persistence of accruals especially in loss years. The evidence presented here also highlights that inferences regarding variation in the accrual anomaly across profit and loss firms are sensitive to the measurement of the accrual component of earnings."


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