Momentum in Australian stock returns.

Abstract: Medium-term momentum, or the tendency of investment strategies based on buying past winning stocks while selling past losing stocks to maintain above normal performance over a period, has been a well-documented feature of stock returns in the US. We investigate the performance of momentum investment strategies in portfolios of Australian stocks and examine some of the common explanations and empirical features of momentum. The paper establishes the presence of a strong medium-term momentum effect, which cannot be completely accounted for by any of the possible explanations considered in this paper.

Keywords: STOCK RETURNS; MOMENTUM PORTFOLIOS; RISK ADJUSTMENT

1. Introduction

Within the context of investment strategy, two interesting challenges to the debate on market efficiency have emerged in recent years. DeBondt and Thaler (1985, 1987) argued that past losers outperform past winners over an investment horizon of three to five years. The profitability of this contrarian investment strategy is attributed largely to the fact that investors over-react to good or bad news. It is generally true to argue, however, that most investors have investment horizons which are shorter than those required for the contrarian approach to yield acceptable returns (De Long, Shleifer, Summers & Waldmann 1990; Shleifer & Vishny 1990). As a consequence, a result which has received relatively more recent attention is due to Jegadeesh and Titman (1993) who demonstrate that past winners outperform past losers over the intermediate horizon of three to twelve months. A momentum strategy, therefore, involves buying past winners and selling past losers. Using returns of individual stocks, Jegadeesh and Titman (1993) established that this strategy produced abnormal returns over horizons of 3 to 1 months. Since this influential work a number of other studies have confirmed and extended this result. Moskowitz and Grinblatt (1999) show that momentum exists in industry-based portfolios while Llewellyn (2002) demonstrates that momentum is also present in size and book-market sorted portfolios. Grundy and Martin (2001) take a longer-term historical perspective and show that a momentum strategy has been profitable in the US since the 1920s. There is thus a solid body of literature documenting that momentum is a robust and pervasive feature of US stocks and there is emerging evidence (Rouwenhorst 1998) to suggest the presence of momentum in European markets.

A number of explanations have been suggested to account for momentum. Some authors have suggested that momentum profits are solely due to data-snooping bias. Jegadeesh and Titman (2001), using data over a sample period subsequent to their earlier paper, show that a momentum strategy continues to be profitable, this result may be taken as evidence against the data-snooping argument.

Conrad and Kaul (1998) argue that the cross-sectional dispersion in mean returns of individual stocks can be an important determining factor in generating momentum profits. One prediction of this explanation would be that the return to a momentum strategy would be positive, on average, for all the post-ranking period. Evidence to the contrary in the US is provided by Jegadeesh and Titman (2001), who show that the performance of momentum portfolios 13-60 months post-formation is negative.

Another popular explanation of momentum is provided by Chan, Jegadeesh and Lakonishok (1996), who attribute momentum to firm-specific events in that investors either under-react to information or that positive feedback trading causes a delayed over-reaction to information. Llewellyn (2002), on the other hand, interprets the profitability of momentum strategies for size and book-market sorted portfolios as evidence against the first-specific behavioural explanations since these portfolios may be regarded as fairly well diversified and therefore reflecting systemic risk. Llewellyn (2002) also provides an alternative view of the behavioural story by focusing on the possible influence of patterns of correlation and autocorrelation in returns as a possible explanation for momentum. In particular, it appears that lead-lag correlations among stocks are stronger than autocorrelations, with a possible behavioural rationale for this phenomenon being that investors mistakenly believe that news about one firm contains news about another.

Given the scale of the recent interest in momentum and the fact that no single persuasive explanation for the phenomenon has emerged, it is perhaps surprising that more has not been written on this score in the Australian context. As a consequence, this paper aims to fill the gap in the literature by investigating the profitability of a momentum investment strategy implemented using the top 200 Australian stocks by market capitalization. The results are then examined further to explore possible alternative explanations for the presence of momentum in Australian stock returns.

The rest of the paper is structured as follows. Section 2 describes the dataset employed and deals with various methodological points related to the construction of the stock returns which are used to examine momentum. In section 3 the basic momentum …