Last Updated on 23 July, 2024 by Trading System
Momentum trading is a popular and effective strategy utilized by investors to capitalize on the upward trends of stocks. However, researchers Suk-Joon Byun and Byoung-Hyun Jeon identified a phenomenon known as “momentum crashes,” which occur when the market rebounds from its lows. Despite extensive research on this issue, a comprehensive explanation for this phenomenon remained elusive until their groundbreaking study, “Momentum Crashes and the 52-Week High.”
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Momentum Crashes and the 52-week High
In their study titled “Momentum Crashes and the 52-week High,” Suk-Joon Byun and Byoung-Hyun Jeon investigate the phenomenon of momentum crashes during market rebounds. They discover a negative relationship between the proximity to the 52-week highs and subsequent returns, which is the underlying cause of momentum crashes. This relationship remains consistent across different risk-control measures, sample periods, and stocks analyzed. Byun and Jeon’s findings align with the sentiment-driven mispricing hypothesis, suggesting that market rebounds lead to increased investor sentiment and speculative demands, causing price run-ups for stocks far from their peaks. To address momentum crashes, they propose a near-high-neutral momentum strategy that overcomes the drawbacks of conventional strategies while maintaining profitability. The implications of their study extend globally, with the near-high-neutral strategy outperforming conventional approaches and reviving momentum profits in Japan, the U.K., and continental Europe.
Unraveling the Negative Relationship
Byun and Jeon’s study shed light on the negative relationship between proximity to the 52-week highs and subsequent returns. They found that momentum crashes are directly influenced by this relationship. Remarkably, this relationship held true across various risk-control measures, sample periods, and stocks examined in the study. Furthermore, it significantly contributed to the time-variation of momentum profits.
The Sentiment-Driven Mispricing Hypothesis
Among several potential explanations explored, Byun and Jeon’s empirical results aligned most closely with the sentiment-driven mispricing hypothesis proposed by Baker and Wurgler in 2007. According to this hypothesis, market rebounds trigger increased investor sentiment, resulting in a surge of speculative demands. Due to anchoring bias, these demands tend to concentrate on stocks that are far from their 52-week highs, causing their prices to rise substantially. Supporting this hypothesis, the study observed a rise in proxies for investment sentiment during market rebounds, as well as an increase in small trades among stocks that are far from their peaks. Interestingly, the outperformance of stocks far from their peaks is found to reverse in the long run.
Designing a Near-High-Neutral Momentum Strategy
Based on the understanding that the proximity to the 52-week high drives momentum crashes, Byun and Jeon devised a near-high-neutral momentum strategy. This strategy successfully addresses the disadvantages associated with conventional momentum strategies, such as high volatility, negative skewness, large negative minimum returns, and pro-cyclicality. Most importantly, unlike the conventional approach, the near-high-neutral momentum strategy maintains its profitability while mitigating the negative impact of market rebounds.
Generalizability and Global Implications
The findings of Byun and Jeon’s study can be generalized to international equity markets. Analyzing markets in Japan, the U.K., and continental Europe, the researchers observed that the conventional momentum strategy consistently yielded negative returns during market rebounds. However, by neutralizing the effect of nearness to the 52-week high, the near-high-neutral momentum strategy reversed this trend and outperformed the conventional strategy across all three markets. Remarkably, the near-high-neutral strategy even revived momentum profits in Japan.
Conclusion
Byun and Jeon’s study provides a comprehensive explanation for the occurrence of momentum crashes during market rebounds. Their findings highlight the negative relationship between proximity to the 52-week high and subsequent returns, linking it to the reversal of momentum profits. The study’s alignment with the sentiment-driven mispricing hypothesis further supports the role of investor sentiment in driving these crashes. Importantly, the near-high-neutral momentum strategy introduced in the study presents a promising alternative that preserves profitability while mitigating the downsides associated with conventional momentum strategies. With its generalizability to international equity markets, this research contributes significantly to our understanding of momentum crashes and their implications for investors worldwide.
FAQ
What are “momentum crashes”?
Momentum crashes refer to a phenomenon identified by researchers where the market experiences a rebound from its lows, leading to a negative impact on stocks that were previously exhibiting momentum. This can result in a reversal of momentum profits.
How do momentum crashes impact conventional momentum strategies?
Momentum crashes can negatively impact conventional momentum strategies, leading to high volatility, negative skewness, large negative minimum returns, and pro-cyclicality.
What is the sentiment-driven mispricing hypothesis?
The sentiment-driven mispricing hypothesis suggests that during market rebounds, increased investor sentiment triggers speculative demands, concentrating on stocks far from their 52-week highs. This can cause substantial price run-ups.
Is the near-high-neutral momentum strategy applicable globally?
Yes, the study’s findings can be generalized to international equity markets. The near-high-neutral strategy consistently outperformed conventional strategies in markets such as Japan, the U.K., and continental Europe.