What Explanation for Momentum Works Best?

Which of the explanations offered in past research best explains, and potentially justifies belief in persistence of, stock return momentum? In the February 2022 revision of their paper entitled “What Explains Momentum? A Perspective From International Data”, Amit Goyal, Narasimhan Jegadeesh and Avanidhar Subrahmanyam test alternative explanations for momentum as hypothesized in earlier studies on a recent international dataset. They each month calculate momentum for each stock as its return over the last 12 months excluding the most recent month, standardized by subtracting the average momentum for all stocks of the same country. They then rank stocks into tenths (deciles) based on country-standardized momentum to form a value-weighted hedge portfolio that is long the winner decile and short the loser decile. They employ hedge portfolio returns to test explanatory powers of measurable proxies for the following rationales:

• Overconfidence that escalates with returns.
• Generally slow diffusion of news among investors.
• Anchoring bias, specified as ratio of current price to 52-week high.
• Frog-in-the-pan (investors underreact to small bits of news that arrive gradually due to limited attention, but react appropriately to shocking news).
• Stock risk that varies with past returns (high for winners and low for losers).

They also examine whether hedge portfolio profitability varies across broad market past return and volatility states. Using data groomed to exclude obvious errors for both listed and delisted stocks across 22 non-U.S. developed markets and 27 emerging markets during 1993 through 2020, they find that: (more…)