Market State Impact on Cross-Sectional and Time-Series Momentum Strategy

A recent paper takes a look on Time-Series (TS) vs. Cross-Sectional (CS) version of momentum strategy. Analysis is made on equities but, in our opinion, has implication also on TS vs. CS momentum strategies on futures.

Authors: Cheema, Nartea, Man

Title: Cross-Sectional and Time-Series Momentum Returns and Market States



Recent evidence on momentum returns shows that the time-series (TS) strategy outperforms the cross-sectional (CS) strategy. We present new evidence that this happens only when the market continues in the same state, UP or DOWN. In fact, we find that the TS strategy underperforms the CS strategy when the market transitions to a different state. Our results show that the difference in momentum returns between TS and CS strategies is related to both the net long and net short positions of the TS strategy.

Notable quotations from the academic research paper:

"The recent evidence on momentum returns suggests that the time-series (TS) strategy proposed by Moskowitz, Ooi and Pedersen (2012) outperforms the cross-sectional (CS) strategy of Jegadeesh and Titman (1993) because of its stock selection abilities. However, Goyal and Jegadeesh (2015) show that the TS strategy outperforms the CS because of the compensation of its net long position instead of its stock selection abilities. They argue that TS is a combination of a zero-net investment strategy and a net long investment in the risky assets, whereas CS is an entirely zero-cost strategy. Therefore, the compensation of the net long investment in risky assets enhances the performance of the TS strategy which not only earns the risk premium relative to the CS strategy but also benefits from market timing because there are more up than down markets.

In this paper, we empirically examine whether the TS strategy outperforms the CS strategy because of its net long position by conditioning momentum returns on market states. We define market states based on lagged 12-month (t-11) and subsequent month (t+1) Centre for Research in Security Prices (CRSP) value-weighted market returns. A market state is identified as UP/UP (DN/DN) when the lagged, and subsequent market returns are both positive (negative). We classify the market state as UP/DN (DN/UP) if the lagged 12-month returns are positive (negative) and the subsequent market returns are negative (positive).

To the extent that momentum returns of the TS strategy exceed the CS strategy because of its net long position as suggested by Goyal and Jegadeesh (2015), then TS momentum returns would be relatively higher in UP/UP market because the net long position would time the subsequent UP market. However, if TS momentum returns exceed the CS because of its active position whether net long or net short, then we should expect relatively higher TS momentum return in market continuations whether UP/UP or DN/DN because the net long (net short) position times the subsequent UP (DN) market. Furthermore, we expect that the TS strategy would underperform the CS strategy in market transitions (UP/DN or DN/UP) because the net long (short) position of the TS strategy negatively times the subsequent DN (UP) market.

Consistent with our expectations, we find that the TS strategy outperforms (underperforms) the CS strategy only in market continuations (transitions). We find that the net long/short position times the market in market continuations which enhances TS momentum returns. However, in market transitions, the net long/short position exhibit negative autocorrelation with the subsequent market returns which results into larger losses for the TS strategy."

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