Last Updated on 3 November, 2022 by Samuelsson
There is a reason momentum investors usually ignore the last month’s returns in their calculation of momentum for any given duration. They know that while stocks that have had positive returns over the last six or twelve months tend to outperform in the coming months, stocks that outperformed in the preceding month tend to underperform the following month.
This is a fascinating and well-known stock market anomaly that you will be eager to learn more about. The short-term reversal effect has been hugely researched, but before we delve into the research finding, let’s first know what the effect is all about.
What does the short-term reversal effect in stocks mean?
The short-term reversal effect is a well-known anomaly in the stock market — stocks with relatively high returns over the past month or week earn negative abnormal returns in the following month or week, while stocks with relatively low returns earn positive abnormal returns.
Because of this phenomenon, momentum investors know that, to exploit the momentum factor, it is best to ignore last month’s returns in their calculation of a stock’s momentum over the chosen period. While stocks that have had positive returns over the last twelve months tend to outperform in the coming months, stocks that outperformed in the current month are likely to underperform in the next month.
As a result, momentum investors typically calculate past price momentum ( for example, a 12-month momentum) as the performance over the last 12 months minus the performance in the previous month to get better results than by just looking at the return over the previous 12 months. This is to remove the influence of the short-term reversal anomaly in their result.
This short-term reversal effect is well known and is typically explained with investor overreaction to news being reversed, once the news has been digested — that is, stocks overreact to positive news and correct afterward, creating short-term reversals. But this is not always the case in all stocks. It is more likely in stocks with low volume.
Now that we know what the short-term reversal effect means, let’s take a look at some of the research findings to know what academics think of the anomaly and why it happens.
Understanding why the short-term reversal effect in stocks works
The short-term reversal effect is well-known and well-researched. So, let’s take a look at some research papers and explore their findings and explanations.
While the short-term reversal anomaly is well-known, researchers believe that exploiting the anomaly requires frequent trading and rebalancing in disproportionately high-cost securities, which would lead to a situation where trading costs prevent profitable strategy execution. That is, the results in documented studies might be interpreted in a way that the abnormal returns of reversal effect create an illusion of profitable investment strategies while, in reality, high trading costs make it difficult to trade them profitably.
However, Groot, Huij, and Zhou in this paper, “Another Look at Trading Costs and Short-Term Reversal Profits”, noted that while several studies report that abnormal returns associated with short-term reversal investment strategies diminish once transaction costs are taken into account, the impact of transaction costs on the strategies’ profitability can largely be attributed to excessively trading in small-cap stocks. The authors observed that limiting the stock universe to large-cap stocks significantly reduces trading costs and applying a more sophisticated portfolio construction algorithm to lower turnover reduces trading costs even further. They found that reversal strategies generated 30 to 50 basis points per week net of transaction costs, which poses a serious challenge to standard rational asset pricing models.
Additionally, the paper presented research about European stocks and found that if the investor invests in stocks with larger market capitalization, the reversal strategy will work. These findings have important implications for the understanding and practical implementation of reversal strategies. Since the turnover of standard reversal strategies is excessively high, the solution is to trade the strategy on stocks with a larger market capitalization. This not only leads to profitable trading but a statistically significant strategy. While the strategy still sells past winners and buys recent losers, it is slightly modified in terms of the market cap of the stocks.
Similarly, in a paper presented in the Federal Reserve Bank of New York Staff Reports in September 2011 titled, “Decomposing Short-Term Return Reversal”, Da, Liu, and Schaumburg noted that the profit to a standard short-term return reversal strategy can be decomposed analytically into four components: 1) across-industry return momentum, 2) within-industry variation in expected returns, 3) under-reaction to within-industry cash-flow news, and 4) a residual. However, only the residual component, which isolated reaction to recent “non-fundamental” price changes, was significant and positive in the data. The authors observed that a simple short-term return reversal trading strategy designed to capture the residual component generated a highly significant risk-adjusted return three times the size of the standard reversal strategy during their 1982-2009 sampling period. This decomposition, therefore, suggests that short-term return reversal is pervasive — apparently greater than previously documented — and driven by investor sentiment on the short side and liquidity shocks on the long side.
Moreover, Miwa in “Short-Term Return Reversals and Intraday Transactions” examined whether a short-term reversal is attributed to past intraday or overnight price movements. The author found that while intraday returns reversed to a significant extent in the following week, overnight returns did not, which implies that the short-term reversal is attributed to past intraday price movements. Also, the reversal of intraday returns was found to be stronger during more volatile market conditions, but it seemed unaffected by fundamental news. These findings seem to support the view that short-term reversals do not occur due to intraday price reactions to fundamental information, but rather, are mainly attributable to price concessions for liquidity providers to absorb intraday uninformed transactions.
Talking about the effects of transaction cost, Frazzini, Israel, and Moskowitz studied the ability of the reversal anomaly to survive trading costs in this paper, “Trading Costs of Asset Pricing Anomalies.” Using nearly a trillion dollars of live trading data from a large institutional money manager across 19 developed equity markets over the period 1998 to 2011, the authors measured the real-world transactions costs and price impact function facing an arbitrageur and applied them to size, value, momentum, and short-term reversal strategies. They found that actual trading costs are less than a tenth as large as previous studies suggested, so the potential scale of these strategies is more than an order of magnitude larger than what the previous studies noted. They also stated that strategies designed to reduce transactions costs can increase net returns and capacity substantially, without incurring significant style drift — although results vary across styles, with value and momentum being more scalable than size, and short-term reversals being the most constrained by trading costs. They, therefore, concluded that these anomalies to standard asset pricing models are robust, sizeable, and tradable.
Taking a different look at the short-term reversal effect, Messmer in this paper, “Deep Learning and the Cross-Section of Expected Returns” studied the anomaly using deep learning in AI. The author trained deep feedforward neural networks (DFN) based on a set of 68 firm characteristics (FC) to predict the US cross-section of stock returns. After applying a network optimization strategy, they found that DFN long-short portfolios could generate attractive risk-adjusted returns compared to a linear benchmark. These findings underscore the importance of non-linear relationships among FC and expected returns, and the results are robust to size, weighting schemes, and portfolio cutoff points. Interestingly, price-related FC, such as short-term reversal and the twelve-month momentum, were among the main drivers of the return predictions.
Finally, Sim and Kim showed that the short-term anomaly is also observed in other markets. In “The effect of short-term return reversals on momentum profits”, they investigated the effect of a short-term stock return reversal on the term structure of momentum profits in the Korean stock market following the works of Goyal and Wahal (2015). Their empirical findings showed that the term structure of momentum is more pronounced when a return reversal lasts up to two months but is substantially weakened when past performance over the last two months is not taken into account for portfolio formation. Thus, their evidence implies that the term structure of momentum profitability arises primarily from a carryover of the return reversal from the previous two months.
The short-term anomaly is typically explained as investor overreaction to news being reversed once the news has been digested — that is, stocks overreact to positive news and correct afterward, creating short-term reversals. This is seen in the work of Stefan Nagel in the paper, “Evaporating Liquidity”. The author claims that returns of short-term reversal strategies in equity markets can be interpreted as a proxy for the returns from liquidity provision and shows that reversal anomaly returns closely track the returns earned by liquidity providers.
However, in their paper titled, “Short-term Momentum”, Medhat and Schmeling found that not all stocks exhibit short-term reversal. According to them, only the stocks with low volume in the previous month show short-term reversals, and this is not just in the U.S. markets but across 22 developed countries.
Another explanation for the short-term anomaly is profit-taking by short-term traders and position accumulation by value investors. After a week or month of favorable price movement and consistent returns, short-term swing traders are bound to take their profits, creating selling pressure in the following week or month. Likewise, after a week or month of sustained decline, value investors see an opportunity to buy the stock on a dip, thereby creating a huge demand for the stock in the following week or month.
Whatever the case, it is generally accepted that the short-term reversal strategy does work, at least theoretically. But there seems to be a problem with the transaction costs, which many believe makes the strategy difficult to implement profitably. However, the work of Groot, Huij, and Zhou in, “Another Look at Trading Costs and Short-Term Reversal Profits” showed that the strategy can perform well if the trader focuses purely on the larger stocks with less volatility and thus lower trading costs. Note that the paper used the Nomura cost estimates rather than the trading cost estimates resulting from the Keim and Madhavan model, which are substantially lower and can even be negative in many cases.
Another attractive feature of the trading cost model, as seen in the Nomura model, is that it was also calibrated using European trade data, thereby making the analysis of the European stocks easy. And finally, it’s clear that the study established that net reversal profits are significant and positive among large-cap stocks in the most recent decade in the sample, a period characterized by the dramatically increased market liquidity. Thus, the explanation that reversals are induced by inventory imbalances by market makers and the contrarian profits are compensation for bearing inventory risks doesn’t seem to hold any merit.
Why you should take note of the short-term reversal effect in stocks
The short-term reversal effect is something you must be aware of and utilize in your trading, even if you are not directly using it as a trading strategy. For instance, if you follow the momentum strategy, you have to factor in the short-term reversal effect in your calculation of an asset’s momentum over your chosen period. For a 12-month momentum, you don’t add the last month’s performance in your calculation.
Furthermore, you can trade the short-term strategy and use it to hedge for stocks during bear markets because it is a liquidity-providing strategy, so it typically performs well during market crises. But you should be cautious though — being also a form of short-volatility strategy; its returns increase mainly in the weeks following large stock market declines. Ensure your risk management is very strict during these days.
How to apply this short-term reversal effect in your stock trading
You may find it difficult to implement this strategy because going long after a huge decline feels like sitting on the way of a falling knife. But if you want to trade it, create an investment universe of about 100 stocks — they must be large-cap stocks.
Here are the rules:
- Buy the 10 stocks with the lowest performance in the previous week or month and short-sell the 10 stocks with the best performance in the preceding week or month.
- Rebalance the portfolio weekly or monthly as the case may be.