FINC3017 Investments and Portfolio Management
Essay: Market Efficiency and Anomalies
Topic：Stock price momentum: Jegadeesh and Titman (1993)
Momentum anomaly and EMH
Anomaly is a stock return deviation that challenge efficient market hypothesis (EMH). Jegadeesh and Titman (1993) theorise price momentum anomaly in the stock market for the first time. It contradicted to efficient market hypothesis thereby is widely debated. EMH states that no consistent excess return can be achieved since security prices fully reflect all available information (Fama 1970). Therefore, future prices cannot be predicted through technical analysis of past prices. If the hypothesis is true, passive ...view middle of the document...
But underperformance will remain worse. Grundy and Martin (2001) show that round-trip cost above 1.5% makes the anomaly unprofitable.
It is difficult to explain price momentum use traditional risk-return model (Fama and French (1996), Grundy and Martin (2001)). But, momentum anomaly exists for reasons. The underlying mechanism of the anomaly can be explained from the perspective of behavioural finance and Knightian uncertainty. Both underreaction and delayed overreaction to the information can cause price momentum.
Barberis, Schleifer and Vishny (1998) show that because of conservatism (Edwards 1968), investors tend to underweighting new information at the beginning. Information slowly spread and slowly incorporates into share price. Therefore, current information can predict future price. Momentum anomaly exists. However, in the long term, overreaction will lead the stock price to reverse which is consistent with De Bondt and Thaler (1985).
Hong and Stein (1999) divide investors into ‘news watchers’ and ‘momentum traders’ groups. It demonstrates different functions of investors rather than cognitive bias. As information gradually circulate among news watchers, underreaction cause price momentum. With momentum traders start trading, market is overreacting, then price revert in the long run. Chan, Jegadeesh and Lakonishok (1996) arrived at the same conclusion. Besides, it asserts the inertia exist because of the prolonged revising of analyst forecasts.
On the other hand, Daniel, Hirshleifer and Subrahmanyam(1998) assume investors are overconfidence to private information. When information spread out, due to self-attribution phenomenon, investors will overreact and generate momentum profit.
Since current risk-return model cannot fully explain momentum effect, there might be some immeasurable risks exist to explain this anomaly. It is called Knightian uncertainty (Knight 1921). Ford, Kelsey and Pang (2005) believe most individuals are ambiguity-averse. When Knightian uncertainty exists, basic value of the stock cannot be estimated accurately. Trading frequency may increase to avoid risk, therefore cause price momentum. Herd behavior might be another reason as well.
However, Du (2012) calls for review explanation to momentum effect because neither risk nor behavioral biases in isolation can explain this anomaly.
Momentum effect across time and countries
Price momentum exists in the US market over time. Jegadeesh and Titman (1993) observe momentum effect from 1965 to 1989. Jegadeesh and Titman (2001) show the effect from 1965 to 1998. Jegadeesh and Titman (2011) confirm the effect exists from 1965 to 2005. Momentum strategy continuous to generate above average since it was first documented in 1990s.
Besides, price momentum was observed in many countries. Rouwenhorst (1998) finds momentum in 12 European countries from 1978 to 1995. Hu and Chan (2011) observe significant continuous excess returns across 48 countries from...