Short-Term Momentum Strategy (16.4% Per Year)

For years, anyone in finance worth their salt could tell you a fundamental truth about stock market patterns: at very short horizons, like one month, stock returns tend to reverse. That meant last month’s losers often became this month’s winners, and vice-versa. We present a short-term momentum strategy for stocks.

But stretch that horizon to 2-12 months, and you’d see the powerful force of momentum—winners kept winning, losers kept losing. It was a clear, if sometimes contradictory, picture.

But what if I told you that this widely accepted wisdom is only half the story? What if reversal and momentum aren’t just distinct phenomena operating at different timeframes, but can actually coexist with striking magnitudes at the exact same one-month horizon?

That’s the groundbreaking discovery revealed in the research paper “Short-term Momentum” by Mamdouh Medhat and Maik Schmeling. Their work fundamentally challenges our understanding of market dynamics by introducing a crucial, often overlooked factor: share turnover.

Related reading: – S&P 500 Momentum Strategy

The Core Discovery: It’s All About Turnover!

The secret sauce to unlocking this simultaneous market behavior lies in how actively stocks are traded.

The researchers utilized a meticulous method called “double decile sorting”:

Imagine taking all U.S. stocks, first sorting them into ten groups based on their previous month’s return (from worst to best performers).

Then, within each of those ten groups, they sorted them again into ten new groups based on their previous month’s share turnover (from thinly traded to heavily traded). This detailed analysis revealed two powerful, coexisting forces:

•(STREV): The Low-Turnover Trap For thinly traded stocks – those with low share turnover – the old rule still holds. If you bought last month’s winners and shorted its losers within this low-turnover group, you’d actually see a negative average return of 16.9% per annum. This is strong evidence of reversal among these less frequently traded assets.

•Short-Term Momentum (STMOM): The High-Turnover Edge Here’s the game-changer: For heavily traded stocks – those with high share turnover – you observe an almost equally strong continuation effect. A strategy that buys last month’s winners and shorts its losers within this high-turnover group generates a positive and significant average return of 16.4% per annum! This is the essence of short-term momentum.

Why This Discovery Matters for Investors

This isn’t just an academic curiosity; the paper demonstrates that short-term momentum is a robust, profitable, and implementable strategy with several compelling advantages:

•Profitability and Persistence: STMOM is not a fleeting anomaly. It’s as profitable and as persistent as conventional price momentum, with its returns continuing for up to 12 months after the portfolio is formed. This gives traders ample time to build and adjust positions, potentially reducing trading frequency and costs. In contrast, STREV returns are much shorter-lived, often fading within just 3 months.

•Survives Transaction Costs: This is crucial for real-world application. The STMOM strategy survives even conservative estimates of transaction costs. The net average return after accounting for these costs is 1.00% per month. Even better, if you skip the last few days of the formation month – which helps avoid liquidity-driven trades – the performance after costs actually improves to 1.45% per month.

•Favors the Giants (High Investment Capacity): Unlike many anomalies that are only effective in small, illiquid stocks, STMOM is strongest among the largest, most liquid, and most extensively covered stocks (megacaps). This is a significant advantage, as it means the strategy is scalable and can be implemented by large institutional investors without encountering capacity constraints. The majority of STREV returns, conversely, come from microcaps.

•Global Phenomenon: The findings aren’t limited to the U.S. market. This pattern extends to 22 developed markets outside the United States, including major economies like Japan, Germany, and the UK. The international STMOM strategy delivered a healthy 1.39% per month, while international STREV showed an even larger reversal of -3.25% per month. This universality suggests a deep, underlying market dynamic.

•Lower Crash Risk: Conventional price momentum is known to suffer from “crash risk,” experiencing significant negative returns during market rebounds. This study found that short-term momentum exhibits far less crash risk than conventional price momentum. STMOM acts as a better hedge in bear markets and does not show negative market exposure during rebounds.

•Not Explained by Common Factors: The researchers meticulously ruled out several typical explanations. STMOM is not primarily driven by earnings announcements, not simply industry momentum, not explained by factor momentum, and is not a result of stock volatility. Its unique nature suggests it captures distinct market information.

The “Why”: Challenging Rationality, Embracing Bounded Rationality

Explaining this short-term momentum effect is where the study delves into financial theory:

•Challenges Rational Models: Traditional “rational expectations equilibrium” (REE) models struggle to explain STMOM. These models often predict that high trading volume due to non-informational liquidity demand should lead to price reversal, which is the opposite of STMOM. Furthermore, some rational models predict continuation for high-information-asymmetry stocks (small, illiquid ones), yet STMOM thrives in the opposite environment: large, liquid, and highly covered stocks.

•The “Boundedly Rational” Explanation: The authors propose an alternative: “boundedly rational” traders. If some traders don’t fully “infer” all the information embedded in prices, this “under-inference” can lead to prices underreacting to available information. This underreaction, in turn, causes persistent price movements or continuation. This aligns perfectly with STMOM being stronger in:

◦Large, liquid stocks: Their prices are less influenced by temporary price pressure, allowing the under-inference effect to be more dominant.

◦Stocks with high analyst forecast dispersion: This is often a proxy for disagreement among traders, and more disagreement could lead to greater under-inference and, thus, more persistent price movements.

•Predicting Fundamentals: Further support for “under-inference” comes from a fascinating finding: the interaction of one-month returns and turnover actually predicts future growth in gross profits and earnings. This suggests that the volume-return relationship contains valuable information about a firm’s fundamentals that not all market participants are immediately inferring from current prices.

Short term momentum strategy international stocks

The findings extend to 22 developed markets outside the United States, including countries like Japan, Germany, and the UK. The international short-term momentum strategy delivered a healthy 1.39% per month, while the international short-term reversion showed an even larger reversal of -3.25% per month.

A New Paradigm for Momentum

In summary, while conventional momentum strategies typically “skip” the most recent month of returns to avoid short-term reversal, short-term momentum embraces the most recent month’s performance, but only for heavily traded stocks.

This subtle but crucial difference in filtering out the reversal effect makes STMOM particularly powerful and applicable to a segment of the market – the largest and most liquid stocks – that has historically been more challenging for traditional momentum strategies.

This research by Medhat and Schmeling doesn’t just reveal a new, robust investment strategy; it offers profound insights into how market participants process information and how understanding the nuances of trading activity can unlock significant opportunities.