Short-Term Momentum and Reversals
Growth trends but value mean reverts
Value investors’ cheaper-is-better philosophy can often lead to buying more of stocks that have suffered recent declines. Yet the momentum literature suggests that stocks trend: stocks that have been going down keep going down, while stocks that have been going up keep going up.
A new paper suggests these two seemingly opposing views might, in fact, be reconcilable. Dimensional Fund’s Mamdouh Medhat and co-author Maik Schmeling find in a new study that recent returns predict different outcomes in different types of stocks. Specifically, low-turnover stocks (e.g., small value stocks) tend to experience reversals, where recent stock declines predict future rebounds, while high-turnover stocks (e.g., large-cap growth stocks) tend to experience momentum, with recent stock declines predicting further declines.
The below graph illustrates the key finding. Low-turnover stocks exhibited significant short-term reversals, while high-turnover stocks exhibited short-term momentum.
Figure 1: Coexistence of Reversal and Momentum in 1M Returns
Source: Medhat and Schmeling
The double sorts also showed significant one-month reversal for the bottom seven turnover deciles, and the magnitude of the reversal weakened with turnover until it switched signs and became positive in the highest turnover decile.
The short-term momentum strategy is persistent for 12 months after formation, while the short-term reversal strategy is indistinguishable from zero 3 months after formation. This suggests that short-term momentum captures strong and persistent price movements among the high-turnover stocks, and short-term reversal captures the easing of temporary price pressure among low-turnover stocks.
Figure 2: Short-Term Momentum’s Persistence
Source: Medhat and Schmeling
Medhat and Schmeling contribute to the research on short-term signals by showing a pattern in US stock market returns. Their main finding is that high-turnover stocks exhibited short-term momentum with significant premiums and that low-turnover stocks fully explain short-term reversal. They conclude: “Our results are difficult to reconcile with models imposing strict rationality but are suggestive of an explanation based on some traders underappreciating the information conveyed by prices.”
The study shows interesting similarities to an article we wrote in 2020 on growth and value trends. We showed that trend following based on the last 12 months was most effective among large growth stocks, whereas it reduced returns for small value stocks. “Value is mean reverting. Growth trends.” This opens the question for further research on whether short-term momentum and growth trends are the same effect or have significant differences.
Acknowledgment: This piece was authored by Henry von der Schulenburg, a rising junior at Harvard. He concentrates in applied mathematics and economics and was recently elected captain of the Harvard men’s varsity tennis team. In 2022 he achieved All-American status for the first time. He is looking for internships in consulting or finance next summer.