Market Efficiency in an Irrational World

Traditionally, economic theory takes the view that investors are rational; but several behavioral biases such as Overconfidence have been studied recently.  In particular, this overconfidence has been found to indirectly cause investors to underweight or overweight new information (caused by the "cognitive dissonance", "attribution bias", and "conservatism bias"), contributing to the momentum effect.  The authors propose that growth stocks (i.e., low book-to-market ratios) should exhibit higher momentum due to their value being less predictable (e.g., most of their assets are intangible) than more stable stocks.

The authors study the July 1963 - December 1997 period in the United States equity markets and find that stocks with high Book-to-Market characteristics (i.e., value stocks) and high TTM returns (i.e., momentum stocks) significantly outperformed their growth and low momentum counterparts, as well as the market portfolio.  The value/momentum portfolio outperformed the market portfolio by almost 0.60% per month.

The authors introduce "adaptive efficiency", which relaxes the efficient market hypothesis by adding behavioral theory.  They suggest that the "irrational investors" may tilt their portfolios to anomalies, while the "rational investors" assume that anomalies are corrected by rational investors and will not try to exploit the anomalies; and this will cause the anomalies (such as momentum) to persist.  The authors prove this to be the case over the 1974 - 1997 period in the United States equity markets.

DANIEL, K., & TITMAN, S. (1999). Market Efficiency in an Irrational World. Financial Analysts Journal, 55.

The Profitability of Momentum Strategies

The authors study the effects of price and earnings momentum over the period 1973-1993 in the United States equity market.  They find that winners over the past 6 months significantly outperform losers over the next 6-12 months.

Drilling in, they find that price momentum produces better returns for longer holding periods than earnings momentum.  They contribute this to the theory that earnings is more of a short-term measure; whereas price changes could be due to very long-term changes.  They even found these things to be true for large-cap stocks, which would be expected to not exhibit as much momentum capture due to their better and more public information than that of small-caps.

They contribute this effect to several possibilities: the market does not fully respond to new information, due to investors' conservatism bias (where they are reluctant to change prior opinions); or maybe by analysts being slow to revise estimates.  They note that the momentum effect is not caused by the trades of trend chasers, because there is no subsequent reversal to bring the stock back to equilibrium (even out to the 3rd year).

Chan, L. K. C., Jegadeesh, N., & Lakonishok, J. (1999). The Profitability of Momentum Strategies. Financial Analysts Journal, 55(6), 80.