Morningstar Magazine - December/January 2015 - 48

Strategies

Momentum, Acceleration, and Reversal
How accelerated stock-price increases
lead to drops and poor future performance.

Quant U

P O RT F O L I O C O N S T R U C T I O N

Portfolio Theory Evolving: Markowitz 2.0

Overreaction to Sinking Oil Prices
A Value Strategy That Doubles Down
When Stocks Get Cheaper

A more detailed version of this article
will be published in the Journal of Investment
Management, spring 2015.

Best Ideas

Accelerated stock-price increases are a
strong contributor to both poor future performance
and a higher probability of sudden declines.
The evidence implies that accelerated growth is
not sustainable and can lead to drops. The
acceleration mechanism is also able to reconcile
the well-documented two-to-12-month
momentum phenomenon with the one-month
reversal phenomenon.

James X. Xiong and Roger G. Ibbotson

Investment Research
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Defensive Specialist
A Natural Diversifier
Healthy Relationships

Background

The relative historical performance of stocks has
been studied extensively. Lehmann (1990)
shows evidence of short-term "reversals" that
generate abnormal returns to contrarian strategies
that select stocks based on their performance
in the previous month-the well-known
"one-month reversal strategy." On the other hand,
Jegadeesh (1990) and Jegadeesh and Titman
(1993, 2001) show robust profits to momentum
strategies that buy stocks based on previous
two-to-12-month returns. More recently, Heston
and Sadka (2008) document an interesting
seasonality pattern (up to 20 annual lags)
superimposed on the general momentum/reversal
patterns. Interestingly, Novy-Marx (2012)
shows that momentum can be mostly explained by
seven-to-12-month returns prior to portfolio
formation and that recent six-month returns are
irrelevant; thus, as he says, momentum is
not really momentum. Novy-Marx was right in that
more recent lags don't show momentum;

Morningstar December/January 2015

they show acceleration. We will see next that, on
average, lags 3 to 12 have positive momentum,
while more-recent lags (1 and 2) show acceleration,
which leads to reversal.
What drives momentum and reversal is still not
very clear. Popular explanations include underreaction to news in an intermediate horizon, such
as six months, and overreaction in a short horizon,
such as one month. In this paper, we attempt
to reconcile these two opposite findings with some
new thoughts. Our hypothesis is that the
momentum strategy leads to an accelerated price
increase, perhaps via positive feedback-
that is, momentum followers buy rising stocks,
quickening their rise. However, the acceleration is
not sustainable because it is based on technical
factors rather than positive fundamental
characteristics, hence the reversal. Sornette (2003)
used an earthquake model to quantify how
accelerated assets can eventually crash. Focardi
and Fabozzi (2014) suggested that an accelerating
gap between asset value and the economy
leads to unstainable situations. Indeed, we show
evidence that accelerated price increase is a
strong contributor to poor future performance.
Little research has been performed on single-stock
crashes on a cross-sectional basis. Chen,
Hong, and Stein (2001) use skewness as a measure
for single-stock crashes and show that crashes
are more likely to occur in individual stocks
that (1) have experienced an increase in trading
volume relative to the trend over the prior six
months, (2) have had positive returns over the prior
36 months, and (3) are relatively large in terms of
market capitalization.
We show that accelerated returns also increase
the likelihood of individual stock drops, and thus

Morningstar Magazine - December/January 2015

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