PDF Ebook Long-Term Momentum Hypothesis: New Contrarian Strategy
This paper proposes a new hypothesis that price momentum becomes stronger as the history of a trend in stock price is longer. It, referred to the long-term momentum hypothesis, provides two key predictions. First, the contrarian strategy, suggested by the previous studies, will not obtain profits in the short run. On the other hand, Barberis et al. (1988) predicts that it will earn profits even in the short run. Second, a new contrarian strategy, designed for exploiting long-term momentum, will be short-term profitable. Empirical results established by this study are consistent with the long-term momentum hypothesis. However, other hypotheses fail to explain them.
Financial literature documents two stylized facts such as long-term reversal and short-term momentum in stock prices. Evidence on these two anomalies is strong, but what causes them is still controversial. On the side of market efficiency, behavioral finance theories successfully explain those anomalies by using established psychological behaviors of investors. However, some scholars cast doubt on the validity of their theories. For example, Fama (1998) point out that while behavioral models do well in explaining anomalies that they are designed to explain, they fail to explain other anomalies. He argues that as a rule of scientific endeavor, the effectiveness of a model should be evaluated on the basis of a rejectable prediction that has not yet been tested. This paper attempts to challenge Fama's argument by providing a new behavioral hypothesis and performing new rejectable tests that have not been tested.
This paper proposes a new hypothesis that price momentum becomes stronger as the history of a trend in stock price is longer. This hypothesis, referred to the long-term momentum hypothesis, provides a new prediction of short-term profitability on contrarian strategies, while it also successfully explains the long-term reversal and short-term momentum.
DeLong et al. (1990) and Daniel et al. (1998) explain two stylized facts by using price momentum. They argue that overreaction has two phases. In the initial overreaction phase, overreaction continues, leading to short-term momentum. In the following correction phase, the initial overreaction is gradually reversed in the long run, causing long-term reversal in stock price. Such an overreaction pattern successfully accounts for short-term momentum as well as long-term reversal. Thus, if their arguments are right, price momentum is more likely to occur in the short run rather than in the long run.
Their arguments, however, do not seem to be consistent with the experimental evidence of Andressen and Kraus (1988). They find that when the stock price exhibits a trend, subjects tend to chase the trend; they begin to buy more when prices rise and sell when prices fell. Such trend chasing appears to be a virtually universal phenomenon among the subjects in their experiment. It is noteworthy that this momentum trading appears to occur only in response to significant changes in the price level over a substantial number of observations, not in response to the most recent price changes alone. This result suggests that momentum trading is more likely to occur in the long run than in the short run, which is opposite of interpretation by DeLong et al. (1990) and Daniel et al. (1998). In fact, financial literature implicitly limits the possibility of continuing overreaction to a short-term period, probably for the lack of evidence on long-term momentum.
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PDF Ebook Long-Term Momentum Hypothesis: New Contrarian Strategy
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