23 Feb Learning From "Absolute Strength: Exploring Momentum in Stock Returns"

Stocks that have significantly increased in value in the recent past (absolute strength winners) continue to gain, and stocks that have significantly decreased in value (absolute strength losers) continue to lose in the near future. Absolute strength momentum does not expose investors to severe crashes during crisis periods, and its profits are remarkably consistent over time. We uncover similar results when we vary the sorting period for cumulative returns between 3 and 12 months.

In this article, Absolute Momentum will be used interchangeably with trend following or time series momentum. Relative Momentum will be used interchangeably with cross-sectional momentum or relative strength.

The paper refers to “Absolute Strength Momentum” in this way:

The strategy buys the stocks with the highest positive returns (absolute strength winners) and sells the stocks with the lowest negative returns (absolute strength losers) over the recent past. To be classified as an absolute strength winner (loser), a stock must have a recent cumulative return in the top (bottom) 10% of the historical cumulative return distribution.

The main absolute strength momentum strategy that we examine identifies stocks with extreme upward (downward) moves over the period t-12 to t-2, and tracks their performance over month t.

Absolute strength momentum combines information from the most recent distribution of cumulative returns with information from the historical distribution of cumulative returns. For example, although the 3% cumulative return of NRDC Acquisition Corp over the period from March 2008 to February 2009 is positive, its performance does not place in the top 10% of the historical distribution which is defined by a return higher than 66% for an 11-month sorting period in March 2009. Therefore, NRDC Acquisition Corp does not qualify as an absolute strength winner in March 2009. On the other hand, the 172% cumulative return of Corinthian Colleges Inc over March 2008 to February 2009 qualifies it to be included in an absolute strength winner portfolio. The key innovation of the absolute strength momentum strategy is the use of consistent thresholds in classifying stocks into winners and losers. These consistent breakpoints naturally arise from the use of the historical distribution of cumulative returns. Specifically, at the beginning of each month t, we compute the cumulative returns of all stocks over the period t-12 to t-2.8. To determine whether these cumulative returns are high or low, we look at the distribution of all previous non-overlapping 11-month cumulative returns. For example, at the beginning of January, we record cumulative returns for all stocks over the period from last January to last November. These returns are ranked on the basis of the historical distribution of January to November cumulative returns of all stocks in all times. If a stock’s cumulative return over t-12 to t-2 falls in the top (bottom) 10% of the historical distribution, we classify that stock as an absolute winner (loser). We repeat this process every month. Therefore, our return breakpoints assure that an absolute winner is an asset that has done well over the recent 11 months according to the historical record. Similarly, an absolute loser is an asset that has done poorly over the recent 11 months according to the historical record. Therefore, each month we effectively compare the distribution of cumulative stock returns over the recent past to the historical distribution of 11-month cumulative stock returns.

Stocks that have significantly increased in value in the recent past (absolute strength winners) continue to gain, and stocks that have significantly decreased in value (absolute strength losers) continue to lose in the near future. Absolute strength momentum does not expose investors to severe crashes during crisis periods, and its profits are remarkably consistent over time. We uncover similar results when we vary the sorting period for cumulative returns between 3 and 12 months.

To implement the absolute strength momentum strategy, we require that both the absolute strength winner and loser portfolios have an adequate number of firms for a hedge strategy. We argue that this is represented by 30 stocks. If, in a given month, there are not enough firms in either the absolute strength winner or loser portfolio to implement a hedge strategy, then we invest in the one-month T-bill.

Absolute strength momentum subsumes the information contained in relative strength momentum. However, the reverse does not hold. Absolute strength and relative strength momentum are different. Absolute strength momentum represents a new pattern in returns that cannot be explained by conventional factors.

Absolute strength momentum subsumes the information contained in time series momentum but the reverse does not hold. While time series momentum identifies winners and losers based on positive or negative excess returns, absolute strength momentum identifies them based on significantly positive or negative returns with respect to the historical benchmark. Results reported previously reveal that the strength of the momentum that stocks experience over the t-12 to t-2 period is key in predicting future momentum continuation.

Research Paper: Absolute Strength: Exploring Momentum in Stock Returns

Authors: Huseyin Gulen, Ralitsa Petkova

Organisations: Purdue University, Case Western Reserve University