Asymmetric Momentum Effect Under Uncertainty

Review of Finance (2010), 129 doi: 10.
1093/rof/rfq021
Asymmetric Momentum Effects Under Uncertainty

Downloaded from http://rof.oxfordjournals.org/ at Universiteit van Tilburg / Tilburg University on April 24, 2012
DAVID KELSEY1 , ROMAN KOZHAN2 and WEI PANG3

1
University of Exeter; 2 University of Warwick; 3 Kingston University
Abstract. This paper studies asymmetric profitability of the momentum trading strategy. When investors face Knightian uncertainty, they react differently to past winners and losers, which creates asymmetric patterns in price continuations. This asymmetry increases with the level of market and idiosyncratic uncertainty relating to the fundamental value of stocks. We provide a model explaining this phenomenon and empirical evidence supporting the hypothesis. Our results also imply that momentum is more likely to continue for downward trends in a highly uncertain market. JEL Classification: D81, G11, G12
1. Introduction
A large body of literature has documented the existence of momentum strategies in stock trading: buying past winners and selling past losers generates significant average profit. Most of the evidence concerns the predictability of time-series variation in stock returns (Jegadeesh and Titman (1993), Chan et al. (1996), Rouwenhorst (1998), Moskowitz and Grinblatt (1999), Lee and Swaminathan (2000)). The interpretation of the evidence on return momentum is mainly based on behavioural biases such as underreaction or overreaction to new information (see Barberis et al. (1998), Daniel et al. (1998), Hong and Stein (1999)). Specifically, Hong and Stein (1999) consider the interaction of newswatchers who under-react to the news and trend followers who create overreaction to the news. De Long et al. (1990) model the overreaction to the signal through the behaviour of positive feedback traders who despite the presence of arbitragers in the market create momentum effects. The mechanism in these models works as follows. Investors who trade on the fundamental value of the asset react to signals concerning the fundamental value and cause the price to change accordingly. Momentum traders who trade on the price
We thank participants of the workshop Market Complexity at the University of Warwick and the research seminar at Kingston University for helpful comments. Special thanks go to Vince Daly, Subrata Ghatakfor, Cars Hommes, Mark Salmon, Author Shaw, Willem Spanjers, Wing Wah Tham, the editor and an anonymous referee for their helpful comments. We gratefully acknowledge financial support from EU NEST STREP, FP6 Grant on Complex Markets, no. 516446, which made the project possible.
C The Authors 2010. Published by Oxford University Press [on behalf of the European Finance Association]. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org
D. KELSEY ET AL.
trend observe the price change and enter the market pushing the price further, thus creating the overreaction pattern. In these models, one of the key factors determining the strength and magnitude of the momentum effect in stock returns is investors reaction to information. Furthermore, there are empirical studies showing the difference in price drifting patterns caused by bad news and by good news (Andersen et al. (2007) found such asymmetry in the FX market, Hong et al. (2000), Chan (2003) found it in equity markets, and Beber and Brandt (2009) found it in US bond markets). A recent study by Epstein and Schneider (2008) argued that such patterns can arise due to the presence of Knightian uncertainty (hereafter, we use terms Knightian uncertainty and uncertainty interchangeably). They show that in face of Knightian uncertainty investors overvalue negative information and undervalue positive information. This paper aims to model and test the effect of Knightian uncertainty on momentum returns and the presence of asymmetric patterns between subsequent returns on winner and loser portfolios. Knightian uncertainty refers to situations where objective probabilities are unknown or imperfectly known. It can arise because of missing information, disagreement of expert opinions or lack of confidence in the quality of information. Consequently, it is impossible to describe such ambiguous situations using precise, objective probabilities. One may argue that financial markets are a good place to study the effects of such uncertainty. Facing uncertainty, the majority of people are found to be uncertainty averse, i.e. they prefer choices with better information to similar choices with poor information.1 With uncertainty aversion, people tend to overweight possible worse outcomes and underweight better outcomes. We use maxmin expected utility, introduced by Gilboa and Schmeidler (1989), to model uncertainty-aversion. In this model, people make decisions based on a cautious maxmin criteria: each possible course of action is evaluated with respect to the least favourable probability distribution from a given set of priors. The chosen action is the one for which the minimum expected utility is the highest. The degree of uncertainty-aversion depends on how large the set of priors is. For a small set of priors the resulting preferences only exhibit a small degree of uncertainty-aversion. As a result they are close to the expected utility. A large set of priors would correspond to more extreme types of uncertainty-aversion2 . Our main theoretical contribution is the demonstration that the presence of uncertainty can be a reason for a pronounced asymmetry in momentum returns. We establish a positive relationship among asymmetry, level of uncertainty and the proportion of uncertainty averse investors in the market. We build a model with three types of traders: arbitragers, uncertainty averse traders and momentum traders.
1 2
For the experimental evidence on uncertainty averse behaviour, see Camerer and Weber (1992). Thus an uncertainty averse preference overweighting unfavourable outcomes (not necessarily the worst) is equivalent to maxmin preferences with a smaller set of priors. It is easy to see that our results are held for general uncertainty averse preferences as long as the priors are not unique.
ASYMMETRIC MOMENTUM UNDER UNCERTAINTY
Arbitragers are uncertainty neutral and behave with von Neumann-Morgenstern utility preferences.3 Uncertainty averse traders lack confidence on the distribution of the fundamental value of a stock and hence consider a set of possible priors for the fundamental value. When choosing the distribution of fundamental value, uncertainty averse traders act as if a good signal is unreliable and a bad signal is reliable. Consequently, the aggregated price change triggered by a good signal is less than the aggregated price change triggered by a bad signal. Given the different magnitudes of price change and their demand functions, momentum traders would accordingly create asymmetry between positive and negative price continuation. Finally, we show that such asymmetry would disappear with the absence of uncertainty and uncertainty averse traders in our model. We firstly derive the equilibrium where investors use static optimisation to form their demands. Arbitragers and uncertainty averse traders do not consider the dynamic aspect of a trading strategy while forming their demand in each trading period.4 At the price of this limitation, we are able to obtain illustrative results showing asymmetry in price continuation in relation to the level of uncertainty. To make the arguments general, we further impose full rationality on arbitragers, so that they choose their periodic demand with the strategic consideration of the future path of price and other traders trading behaviour. Thus the trading price of the asset in each period not only clears the market but also satisfies dynamic consistency of arbitragers behaviour. We solve this generalised model numerically and confirm similar findings that asymmetric momentum patterns arise with a positive relationship between the level of uncertainty and the proportion of uncertainty averse traders. In our model, we derive asymmetric responses to good and bad signals through modelling uncertainty concerning the fundamental value rather than the signal quality as suggested in Epstein and Schneider (2008). In doing so, we are able to construct empirical testing for the predictions of the model. We adopt the empirical measurements of stock uncertainty in Zhang (2006) and use a similar data set with a prolonged period. Unlike most previous studies, we investigate separately winner and loser momentum returns realised on firms with different levels of uncertainty. We find that the momentum effect is stronger and more likely to last for losers with a greater level of uncertainty. That is, for stocks with a high level of uncertainty, selling the loser attributes to the greater part of momentum profit. Short-selling stocks with greater uncertainty will realise greater profits following
3
When the degree of uncertainty aversion tends to zero, multiple prior utility converges to von Neumann-Morgenstern utility. 4 This is to assume that different groups of arbitragers and uncertainty averse traders enter the market in each period, and buy and hold until receiving the dividend. An alternative interpretation is that arbitragers behave in a boundedly rational way, as argued in Hong and Stein (1999). They are not time-consistent and do not condition on other traders actions. However, as shown in our general analysis, imposing time-consistency of trading behaviour on arbitrager does not change our results on asymmetry momentum effects of uncertainty.
D. KELSEY ET AL.
negative momentum than buying stocks with greater uncertainty following positive momentum. However, the difference between post-formation returns of losers and winners is not significant for stocks with less uncertainty. The inequality of profit distribution following negative and positive momentum is increasing and only becomes significant with increased uncertainty. To investigate the effect of market uncertainty, we define the market crashes in 1987 and 2000 to be a crisis period and assume a high market uncertainty during this period. We find that asymmetry between negative and positive momentum returns are more profound during the crisis period in comparison to the rest of sample period, named as the non-crisis period in the paper. There are several studies showing the difference in price drifting patterns caused by bad news and by good news (Chan (2003), Hong et al. (2000)). Hong et al. (2000) have observed strong asymmetry in profitability of momentum strategies following past losers and past winners, categorised by market capitalisation and analyst coverage. They attribute the explanation to the gradual-information-flow model in Hong and Stein (1999) and interpret that lower analyst coverage implies slower response to bad news than to good news. In this paper, we use six sorting variables including market capitalisation and analyst coverage, and observe asymmetric patterns with all variables. In contrast to Hong et al. (2000), we argue these sorting variables as proxies for the level of uncertainty rather than the rate of information flow. As our model shows, the dislike of uncertainty by investors causes asymmetry in momentum return. The asymmetric patterns become more prevalent as uncertainty level associated with stocks increases. Our empirical findings are consistent with these predictions. Moreover, in our view, the comparison between the crisis and the non-crisis periods provides exclusive support for our argument that uncertainty accounts for asymmetric momentum returns. It is hard to argue that bad news travels slower than good news during a crisis. Hence we believe that our model and empirical evidence presented in this paper provide an alternative explanation of asymmetric momentum returns. The rest of the paper is organised as follows. In Section 2 we develop the model and establish our testable hypotheses. Section 3 introduces the data and testing methodology. Empirical findings are reported in Section 4. We conclude in Section 5.
2. The Model
We consider a model featuring three types of investors: uncertainty neutral arbitragers (denoted R henceforth), present in the market in a measure , uncertainty averse traders (denoted U henceforth), present in the market in a measure 1 and momentum traders (denoted M), present in the market in a measure . Momentum traders disregard any information about the fundamental value of the stock and
form their demands by extrapolating past prices. Both arbitragers and uncertainty averse traders form their demand based on the difference between todays price and their expectation of the future fundamental value of the stock. The principal difference between those two types is that uncertainty averse traders perceive uncertainty about the fundamental value which is reflected in their demand functions while arbitragers are uncertainty neutral.5 There are three trading periods 0, 1, 2 and 3 and two trading assets, bond and stock. We assume that bond is in perfectly elastic supply and pays zero risk-free rate of return while stock is in a zero net supply. Stock pays a risky dividend is the mean dividend, m + m + i at the end of trading period 3, where d d=d and i are market and idiosyncratic shocks respectively.
2.1 INVESTORS BELIEFS
At time 0, arbitragers and uncertainty averse traders start trading in the market. Arbitragers observe an objective distribution of the dividend 2 , d , dN d
2 2 + 2 is equal to the sum of variances of market and = m where variance d i idiosyncratic components. In contrast, uncertainty averse traders perceive uncertainty about the future dividend payment, namely fundamental uncertainty, which is caused by either the market shock m or the idiosyncratic shock i . We model preferences of uncertainty averse traders using the multi-prior approach developed in Gilboa and Schmeidler (1989). The set of priors for the market shock consists of normal dis2 2 tribution with the set of variance values [m m , m + m ] and the set of mean 2 values [ m , m ], m > m > 0 and m > 0. Priors for the idiosyncratic component of the stock are also described by a family of normal distributions with the variance interval [i2 i , i2 + i ] and means [ i , i ], i2 > i > 0 and i > 0. Since m and i are uncorrelated, the fundamental value d has variance 2 2 , d + ], where = m + i . The set of mean values in the interval [d ,d + ], where d is the mean dividend and = m + i .6 In sum, is [d priors which uncertainty averse traders hold about the future dividend payment are described by a family of normal distributions 2 + , d + , [ , ] and [ , ]. dN d
This captures the idea that uncertainty averse traders have a lack of confidence about the true distribution of the future dividend payments. Note that if = 0 and
5 6
All traders are risk averse. Garlappi et al. (2007) provide an interpretation of parametric sets of multiple priors as confidence intervals around expected returns.
D. KELSEY ET AL.
= 0, there is no fundamental uncertainty perceived in the model and uncertainty averse traders prior beliefs are reduced to a single distribution and coincide with beliefs of uncertainty-neutral arbitragers. The uncertainty averse traders form their expectations according to the multiprior model: , (1) E U (d ) = min E (d ) = d
[ , ]
where the subscript in the expectation operator denotes the prior with respect to which the expectation is calculated. The intuition behind this specification of uncertainty averse preferences is that they do not know precisely the distribution of the true fundamental value of stocks. As a result, instead of using a unique probability distribution, they consider set of priors about the future payoff. Since the traders are uncertainty averse, they choose their investment strategies by maximising the expected utility in the worst-case scenario. Equation (1) indicates that at time 0 uncertainty averse traders discount their expectations about the true price acquiring an ambiguity premium, which is related to the width of the mean interval [ , ]. The uncertainty-neutral arbitragers expectations of the fundamental value is . E R (d ) = d
2.2 DEMAND FUNCTIONS
The demands of both arbitragers and uncertainty averse traders are proportional to the difference between their expectation of future dividend payment and the current price,
I = I ( E I (d ) p 0 ), D0
and,
I > 0,
where I is either R and U. Coefficients I reflect risk tolerance of traders which is allowed to be different for arbitragers and uncertainty averse traders. Momentum traders base their trade at time t only on the price change from t 2 to t 1.7 Their demand for stock at time t is given by DtM = M ( pt 1 pt 2 ),
2.3 PERIOD 0
M Since there is no price changes prior to time 0, D0 = 0, i.e., period 0 provides a benchmark against which the momentum traders can measure changes in stock
7
and
M > 0.
The model is an illustration to a more general case where momentum trading is based on price changes over a particular interval from t k 1 to tk.
ASYMMETRIC MOMENTUM UNDER UNCERTAINTY U R M prices. The market clearing condition D0 + (1 ) D0 + D0 = 0 implies
p0 =
R
R E R (d ) + (1 )U E U (d ) (1 ) , =d R + (1 )U
(2)
where = R + . Since at time 0 there are uncertainty averse traders in (1)U the market who demand an uncertainty premium for holding the stock, there is a price discount at time 0.8 The more fundamental uncertainty is perceived, the wider the interval of the fundamental value of the stock, d, and the greater the price discount is at time 0. At the same time, the price discount depends on the proportion of uncertainty averse traders relative to uncertainty-neutral arbitragers. The fewer uncertainty averse traders there are in the market, the smaller the price discount that is observed.
2.4 PERIOD 1
At time 1, both arbitragers and uncertainty averse traders receive a noisy signal s about the fundamental value of the stock d. Specifically, traders observe s = d + 2 ).9 with N (0, Since uncertainty averse traders perceive uncertainty about the future dividend payoff d variable, they also perceive uncertainty about the distribution of the signal s. Upon receiving the signal s, uncertainty-neutral arbitragers update their probabilistic beliefs in a Bayesian way, so that + E R (d |s ) = d
2
2 d 2 2 d +
) = d + R (s d ) = d + R , (s d
(3)
d where R = 2 + 2 and = s d is the magnitude of the signal relative to the d expected value of the future dividend payoff for arbitragers. Uncertainty averse traders update their beliefs about the fundamental value of the stock by applying Bayes rule to all the likelihoods of the priors to obtain a family of posteriors (see Epstein and Schneider (2008))
++ d |s N d
2 + d
2 d + +
+ )), (s (d 2
2 2 + d 2 2 d + + 2 +
(4)
d with [ , ] and [ , ]. The slope coefficient 2 + 2 indicates the d + extent to which the uncertainty averse traders trust the precision of signal s. 8
Epstein and Schneider (2008) made the same argument about the expectation of uncertainty averse investors. 9 We can extend the model to the case of uncertain noise, as it is done in Epstein and Schneider (2008) but this will not change the main conclusion of the model, so we skip it for the sake of simplicity.
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2 is high relative to the variance of the If the variance of the signal noise 2 fundamental value d , uncertainty averse traders take the information contained in the signal less seriously. If the variance of the fundamental value is high compared to the variance of the noise, the information content in the signal is high and the slope coefficient is higher, thus uncertainty averse traders rely more on the signal. The traders expectation is
E U (d |s ) =
[ , ] [ , ]
min
E , (d |s ) = d ) and U =
+ U ) (s (d )) = d s (d
+ U ,
where = s (d
+ = =
2 d 2 + 2 , d 2+ d 2 + + 2 , d
if 0, if < 0.
Thus, uncertainty averse traders respond to the signal in an asymmetric manner and we have < R < + . The intuition is similar to that in Epstein and Schneider (2008). If the news about d is good (that is, the signal is higher than the lowest ), uncertainty averse traders expected value of the fundamental price s d treat the signal less seriously and react less by using the lower fundamental variance 2 (and by doing so increasing the impact of the noise in the signal). If the d ), uncertainty averse traders view the signal as more reliable news is bad (s < d 2 + . This and react more by using the higher value of the fundamental variance d causes an asymmetric effect in the reaction to news they react stronger to bad news and weaker to good news.10 Arbitragers and uncertainty averse traders demand at time 1 is
I D1 = I ( E I (d |s ) p 1 ),
I = R, U
and again momentum traders do not trade at time 1. The market clearing condition U R M + (1 ) D1 + D1 = 0 implies at time 1, D1 p1 = R E R (d |s ) + (1 )U E U (d |s ) = E R (d |s ) + (1 ) E U (d |s ) R + (1 )U (1 ) + ( (1 ) + A ) R + (1 )U R , (5)
=d =d
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Note that arbitragers measure the magnitude of a signal relative to the expected value of dividend , and uncertainty averse traders measure it relative to the maximin expected value of dividend d . d Since only uncertainty averse traders have different reaction to bad and good signals, the measurement of signal strength is what matters in our analysis.
where A = R + (1 )U is an average response of both uncertainty averse traders and uncertainty neutral arbitragers to the signal s. At time 1, the price consists of four components. The first one is a rational expectation component equal to the mean of the future dividend payoff. The second component reflects the price discount due to the presence of uncertainty averse traders who require a premium for holding the uncertain stock. The third component is the price revision due to the arrival of new information. The sensitivity to new information is a weighted combination of R and U which reflects a consensus sensitivity between arbitragers and uncertainty averse traders. The price will adjust up if there is good news 0, and adjust down if there is bad news < 0. The coefficient U is greater for bad news than for good news, thus, ceteris paribus, the up-movement of price will be less than the down-movement of price. The fourth component is the price adjustment due to the difference in the valuations of signal magnitude by arbitragers (measured as ) and uncertainty averse traders (measured as ). Since we use the measurement of the signal strength in the equation for A , arbitragers responses to new information are adjusted down by in the formation of the market clearing price. Without the presence of the uncertainty averse traders, i.e., = 1, the price p1 + R (s d ) which is revised solely on the expectation of arbitragers becomes d and the asymmetric price movements disappear. If there is no uncertainty, i.e. = 0 and = 0, asymmetry in the reactions to bad and good signals also disappears.
2.5 PERIOD 2
At time 2, there is no new information and both arbitragers and uncertainty averse traders do not revise their beliefs, while momentum traders enter the game. They interpolate prices p0 and p1 to form their demand
M = M ( p 1 p 0 ). D2
Demands of two other traders types are

I = I ( E (d |s ) p 2 ), D2
I = R, U.
We obtain the equilibrium price of the stock at time 2 as a solution of the market U R M + (1 ) D2 + D2 = 0, clearing condition D2 p2 = p1 + M ( p1 p0 ) R + (1 )U (1 ) + (1 + ) ( ) R + (1 )U =d A R (1 ) + (1 + )[ ], =d
(6)
where =
M . R +(1)U
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Period 2 price is a continuation of the price at period 1 due to the demand pressure from momentum traders, whose market proportion is indicated by . Momentum traders buy if they observe a past positive price change and sell on the observed negative price change. Their trades simply amplify the asymmetric price movements created in period 1. At time 3, a dividend d is realised and paid to all traders. Arbitragers make profit on average while the average performance of uncertainty averse and momentum traders depends on their risk appetites and severity of uncertainty in the market. This might suggest that uncertainty neutral arbitragers should dominate the market over time. However, this is only true if attitudes towards uncertainty are independent of other constraints such as wealth and gender. Meanwhile, De Long et al. (1990) provided a general discussion on why momentum traders persist in the long run even though the strategy of chasing the trend might not be profitable. Since this aspect of the model is not closely relevant to the purpose of the paper, we restrict our attention to factors affecting price continuations. The mechanism of the momentum effect is close to Hong and Stein (1999). Momentum traders demands respond to the price change in the past period. They submit a market order to buy when price rises and to sell when price declines. In comparison, arbitragers and uncertainty averse traders demands are driven by current market price and their beliefs about the future fundamental value of the stock. There is a single signal arriving at time 1 which causes arbitragers and uncertainty averse traders to create a price change from time 0 to 1. This price change is picked up and continued by momentum traders at time 2 through a round of momentum trading. The asymmetry appears in our model due to the existence of uncertainty averse traders. While being uncertain about the fundamental value of stock, the traders create different magnitudes of price changes by reacting less on the arrival of good signals than on bad signals. Momentum traders who simply trade on the previous price changes will continue the difference in past price changes under good/bad signals and generate asymmetric momentum effects.
2.6 MOMENTUM AND ITS ASYMMETRIC EFFECT
Note that in the benchmark period with no momentum traders ( = 0), the price continuation is equal to 0. Momentum traders enter the market at time 1 and generate the price continuation during the third period of time as Cont(,
R , ) = p2 p1 = ( p1 p0 ) = R + (1 )U ,
(7)
which increases with the strength of the relative signal .
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Our aim is to emphasise the asymmetric momentum between winners and losers, so for a relative signal > 0 we define Asym(, , ) = Cont(, , ) + Cont(, , ) = [ R + (1 )+ ] R + ()[ R + (1 ) ] R = [2 R + (1 )(+ )],
2 d + 2 d 2( 2 2 d
where, + =
2 d 2 d
+
m
i)
2 2
i)
As analysed before, in the presence of uncertainty, the asymmetric effect arises due to the difference in responses to good (+ ) and bad signals ( ) by uncertainty averse traders. We have Asym < 0 meaning that, ceteris paribus, the reaction to a bad signal dominates the reaction to a good signal. The magnitude of the asymmetry is positively related to fundamental uncertainty including both the market uncertainty and idiosyncratic uncertainty. Specifically, an increasing market uncertainty (higher m and m ) would increase the asymmetric momentum effects while keeping all other parameters of the model fixed. Similarly, stocks with a higher level of idiosyncratic uncertainty (higher i and i ) would also have a higher level of asymmetry. If there is no uncertainty ( = 0 and = 0), the values of slope coefficients will coincide (+ = ), and we have Asym(, , ) = 0. Also, asymmetry in momentum depends on the proportion of uncertainty aversion traders in the market. The more uncertainty-averse traders there are in the market, the larger the magnitude of the asymmetry. If there are no uncertainty averse traders in the market ( = 1), the asymmetric response to new information disappears. We summarise the implications of the model as the following testable hypotheses. Hypothesis 1. Due to fundamental uncertainty, negative momentum effects are greater than positive momentum effects. Hypothesis 2. The more idiosyncratic uncertainty is, the more profound the asymmetry between realised negative and positive momentum profits. Hypothesis 3. An increase in market uncertainty leads to an increase in crosssectional asymmetry of momentum return.
2.7 FULLY RATIONAL ARBITRAGERS
Following Hong and Stein (1999), we do not consider the dynamic nature of the arbitragers trading strategy in the above model. However, it is natural to ask
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D. KELSEY ET AL.
Figure 1. Equilibrium Prices and Momentum Asymmetry with Fully Rational Traders. The figure presents equilibrium prices when fully rational traders are present in the model. The left panel presents price paths with good news (upper lines) and bad news (lower lines) for different level of uncertainty. The right panel presents the measure of momentum asymmetry for different levels of 2 = 0. We set d = 0.5 and = uncertainty. Parameters are = 0.5, = 0.4, d = 1, 2 = 0.2 and d 0.5 to represent positive news and = 0.5 and d = 0.5 to represent negative news. We compute prices for a set of 5 uncertainty levels, U1( , ) = U(0, 0); U2( , ) = U(0.01, 0.2); U3( , ) = U(0.02, 0.4); U4( , ) = U(0.03, 0.6) and U5( , ) = U (0.04, 0.8). In the left panel, the slope of the price path following bad news is much steeper than the one following good news for higher uncertainty level such as U5. In the right panel, the measure of asymmetry has a clear downward slope indicating larger asymmetry for higher levels of uncertainty and asymmetry disappears in U1 when we have = 0 and = 0.
whether our basic results presented in the previous section will continue to hold if arbitragers are fully rational. In this section, we solve the model by assuming that uncertainty neutral arbitragers trade strategically in each period with consideration of the future price path in addition to the expected value of liquidated dividend and current market price. We use backward induction to derive arbitragers optimal demand in each period so that their final wealth is maximised. Unfortunately the equilibrium results in this case become mathematically cumbersome and lose their intuitive interpretation. Thus we present here a graphic illustration of our numerical solutions. As shown in Figure 1, our main results and conclusions regarding the momentum asymmetry remain similar in the context of fully rational arbitragers. Firstly, we see that the slope of the price path following bad news is much steeper than the one following good news for higher uncertainty level such as U 5. Such asymmetry is originated in period 0 to 1 and continued in the momentum effects appeared in period 1 to 2; second, in the benchmark case U 1 of no uncertainty ( = 0 and = 0), the momentum effect still exists, however, the price reactions to good and bad signals are perfectly symmetric. The right panel of the figure summarised the findings. The measure of asymmetry has a clear downward slope indicating larger asymmetry for higher levels of uncertainty and asymmetry disappears in U 1 when = 0 and = 0.
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3. Data and Methodology

Our sample consists of all firms listed on the NYSE, the AMEX and the NASDAQ during the period January 1983 through December 2005. The stock return data are from the Center for Research in Security Prices (CRSP) Monthly Stocks Combined File. In our sample, we exclude ADRs, REITs, closed end funds, and primes and scores from the analysis. We also exclude stocks with a share price below $5 and higher than $1000 at the portfolio formation date and as well as firms with less than 12 months of past return data on CRSP. Book value and other financial data are from Compustat. Analyst forecast revisions and analysts coverage data are from I/B/E/S. Following Zhang (2006) we delete observations for which the absolute value of earnings forecast revision exceeds 100% of the prior year-end stock price. There have been few studies on the empirical measurement of ambiguity in the literature. Zhang (2006) proposed six proxies for uncertainty and argued their suitability. These proxies are mainly variables describing firms characteristics. We adopt this approach and use the same proxies to measure the uncertainty level relating to a firm. The first variable is firm size measured as the market capitalisation (MV) at the beginning of each period for ex ante returns. The second variable is firm age (AGE) measured as the number of years since the firm was first covered by CRSP. The third variable is analyst coverage (COV) measured as the number of analysts following the firm in the ex ante period. The fourth proxy is stock volatility (SIGMA), which is measured as the standard deviation of weekly excess return over the period for calculating ex ante return. The fifth variable is dispersion in analyst earnings forecasts (EFD) measured as the standard deviation of analyst forecasts scaled by the prior ex ante period-end stock price to mitigate heteroscedasticity. The sixth variable is cash flow volatility (CVOL) which is the standard deviation of cash flow from operations in the past 5 years. In order to implement the momentum strategy, we calculate cumulative return Rt 12,t 1 for the past 12-month period from t 12 through t 1 months prior to the portfolio formation. The performance of the strategy is based on the future one-month returns Rt +1 for the period t to t + 1. Following Jegadeesh and Titman (1993), we also form the portfolios and calculate the returns for 6 6 momentum strategies to increase the power of our tests. Table I presents descriptive statistics and the correlation matrix for variables of interest and the general patterns are similar to those that are found in Zhang (2006). The mean monthly return has a slight right skewness in the distribution, for instance, for Rt +1 , we have 1.10% as the mean and 0.52% as the median. There is a large variation in firm size and age in the sample. Firm age has the median of 12 indicating that young firms account for a big portion of the sample. In contrast to
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Table I. Descriptive Statistics and Correlation Matrix
D. KELSEY ET AL.
This table provides descriptive statistics for variables used in the analysis. Rt +1 denotes returns from month t to t + 1, Rt +6 is accumulated returns from month t to t + 6, Rt 12,t 1 is accumulated returns from month t 12 to t 1, Rt 6,t 1 is accumulated returns from month t 6 to t 1. Firm size (MV) is the market capitalisation (in millions of dollars) at the end of month t. Firm age (AGE) is the number of years since the firm was first covered by CRSP. Analyst coverage (COV) is the number of analysts following the firm in the previous year. Earnings forecast dispersion (EFD) is the standard deviation of analyst forecasts in month t scaled by the prior year-end stock price. Stock volatility (SIGMA) is the standard deviation of weekly market excess returns over the year ending at the end of month t. Cash flow volatility (CVOL) is the standard deviation of cash flow from operations in the past 5 years (with a minimum of 3 years), where cash flow from operations is earnings before extraordinary items minus total accruals estimated from the balance sheet approach, scaled by average total assets. Stocks with a price less than $5 are excluded from the sample. The sample period is from January 1983 to December 2005.
Panel A: Descriptive Statistic N Rt +1 Rt +6 Rt 12,t 1 Rt 6,t 1 MV AGE SIG CVOL COV EFD 928614 918742 918702 926766 923995 928614 918702 647103 638244 398966 Mean 1.10% 6.61% 25.53% 13.06% 4048.6 16.56 1.88% 0.16 8.36 0.67% St. Dev 13.45% 36.09% 76.48% 46.73% 26915.2 15.06 6.71% 5.73 8.39 2.51% Min Q1 Med. Q3 Max
98.13% 5.36% 99.50% 12.29% 97.56% 9.43% 96.89% 8.84% 0 68.49 2 6 0 0.43% 4.6106 5.9103 1 2 0 0.072%
0.52% 6.94% 1034% 4.17% 21.25% 3110% 13.15% 40.89% 4998% 6.97% 25.43% 3753% 265.82 1240.02 1.106 12 22 81 0.91% 1.92% 1376% 0.02 0.08 1871.4 5 11 63 0.21% 0.57% 141.9%
Rt +6 Rt +1 Rt +6 Rt 12,t 1 Rt 6,t 1 MV AGE SIG CVOL COV 0.374 1
Rt 12,t 1 0.006 0.002 1
Rt 6,t 1 0.011 0.024 0.695 1
Panel B: Correlation Matrix MV AGE SIG 0.005 0.011 0.003 0.002 1 0.007 0.014 0.057 0.045 0.189 1 0.017 0.042 0.265 0.238 0.020 0.088 1
CVOL 0.004 0.010 0.066 0.051 0.002 0.017 0.097 1
COV 0.000 0.001 0.029 0.033 0.316 0.329 0.044 0.083 1
EFD 0.019 0.028 0.030 0.014 0.041 0.012 0.044 0.032 0.031
Zhang (2006), stock returns are not very volatile, as suggested by a mean SIGMA of 1.88% per week and a median of 0.91% per week. Panel B shows that firm size (MV), firm age (AGE) and analyst coverage (COV) are positively correlated with each other but negatively correlated with stock volatility (SIG), cash flow volatility (CVOL) and earnings forecast dispersion (EFD). This supports the idea that these proxies reflect the same property of a firm.
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Based on these measurements, we tested our hypotheses by assigning stocks to portfolios based on past returns and the uncertainty level associated with the stock. The following section provides the results of the comparison of the portfolio returns by momentum and uncertainty proxy.
4. Empirical Findings
4.1 PORTFOLIO RETURNS BY MOMENTUM AND UNCERTAINTY PROXY
We follow the treatments used in Jegadeesh and Titman (1993) and calculate the stock returns of JK trading strategy, where stocks are selected on the basis of returns over the past J months and held for K months. In this paper, we test our hypotheses respectively for two trading strategies, 12 1 and 6 6 strategies. We rank the stocks in descending order on the basis of Rt J ,t 1 returns and construct five equally weighted portfolios. We consider the upper and the lower quintile portfolios as winners and losers portfolios representing positive and negative momentum respectively. Stocks in each of these portfolios are ranked according to their uncertainty proxy and five sub-portfolios are formed. These portfolios are rebalanced every month and their following monthly return is calculated. The stocks in uncertainty quintile 1 (denoted U1) are regarded as the least uncertain and the stocks in uncertainty quintile 5 (denoted U5) are regarded as the most uncertain. This results in 10 equal weighted portfolios for each uncertainty proxy for each trading strategy. Table II shows the main results for momentum returns for 12 1 trading strategy based on momentum and uncertainty proxies. We firstly examine variation in portfolio returns for winners and losers respectively by each uncertainty level and verify the existence of momentum effects. Portfolios at all uncertainty levels have higher returns following winners than following losers. The momentum effects are more significant for portfolios with higher uncertainty levels. The results are applied to all uncertainty proxies and confirm an implication suggested by Zhang (2006) that momentum trading strategies should work better for portfolios with more uncertainty. For example, for AGE proxy and the portfolio at uncertainty quintile 1, the post momentum return is 0.67%; however, the post momentum return of U5 portfolio by buying the winners and selling the losers is 2.41%. The focus of the paper is on the separate comparison of positive and negative momentum returns across uncertainty levels. We observe that, for all uncertainty proxies, portfolios with more uncertainty have lower returns following past losers than portfolios with less uncertainty. The results are less unified for the returns following winners. Portfolios with more uncertainty have higher returns following winners than portfolios with less uncertainty for 4 proxies except proxies MV and
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Table II. Positive and Negative Momentum Returns and Asymmetric Effect (12 1) The table reports average monthly portfolio returns sorted by price momentum and uncertainty proxy. Each month we first sort stocks into five quintiles based on returns from months t 12 to t 1. For each momentum quintile, we further sort stocks into five groups based on uncertainty proxy. Firm size (MV) is the market capitalisation (in millions of dollars) at the end of month t. Firm age (AGE) is the number of years since the firm was first covered by CRSP. Analyst coverage (COV) is the number of analysts following the firm in the previous year. Earnings forecast dispersion (EFD) is the standard deviation of analyst forecasts in month t scaled by the prior year-end stock price. Stock volatility (SIGMA) is the standard deviation of weekly market excess returns over the year ending at the end of month t. Cash flow volatility (CVOL) is the standard deviation of cash flow from operations in the past 5 years. Stocks are held for 1 month, and portfolio returns are equally weighted. The sample period is from January 1983 to December 2005; t-statistics in parentheses are adjusted for autocorrelation.
Uncertainty Proxy: MV Neg. U1 U2 U3 U4 U5 0.90% 0.58% 0.20% 0.10% 0.54% Pos. 2.03% 1.82% 1.79% 1.69% 1.46% Momentum 1.13% (1.98) 1.24% (2.10) 1.59% (2.67) 1.79% (3.16) 2.00% (3.79) Asym. Eff 2.92 (5.10) 2.40 (4.08) 2.00 (3.35) 1.60 (2.82) 0.92 (1.75) Neg. 0.95% 0.73% 0.42% 0.00% 0.67% Uncertainty Proxy: AGE Pos. 1.63% 1.93% 1.89% 1.94% 1.75% Momentum 0.67% (1.39) 1.20% (2.26) 1.47% (2.58) 1.94% (3.24) 2.41% (3.84) Asym. Eff 2.58 (5.31) 2.65 (4.99) 2.31 (4.05) 1.94 (3.24) 1.08 (1.72)
Uncertainty Proxy: SIGMA Neg. U1 U2 U3 U4 U5 0.71% 0.59% 0.30% 0.08% 0.50% Pos. 1.73% 1.73% 1.93% 1.84% 1.55% Momentum 1.02% (2.79) 1.14% (2.40) 1.63% (2.85) 1.93% (2.97) 2.06% (2.64) Asym. Efft 2.44 (6.68) 2.33 (4.88) 2.24 (3.91) 1.76 (2.71) 1.05 (1.35) Neg. 0.73% 0.68% 0.35% 0.08% 0.40%
Uncertainty Proxy: CVOL Pos. 1.55% 1.76% 1.87% 1.91% 1.80% Momentum 0.83% (1.74) 1.08% (2.04) 1.52% (2.59) 1.83% (2.71) 2.20% (2.95) Asym. Eff 2.28 (4.82) 2.45 (4.64) 2.23 (3.80) 1.99 (2.94) 1.40 (1.88)
Uncertainty Proxy: COV Neg. U1 U2 U3 U4 U5 0.56% 0.68% 0.37% 0.03% 0.26% Pos. 1.80% 1.86% 2.01% 2.08% 1.85% Momentum 1.24% (1.98) 1.18% (1.91) 1.64% (2.70) 2.06% (3.56) 2.12% (3.83) Asym. Eff 2.36 (3.77) 2.54 (4.10) 2.39 (3.92) 2.11 (3.64) 1.59 (2.88) Neg 0.62% 0.54% 0.35% 0.17% 0.44%
Uncertainty Proxy: EFD Pos. 2.35% 1.96% 1.72% 1.65% 1.59% Momentum 1.73% (2.80) 1.42% (2.33) 1.37% (2.22) 1.48% (2.29) 2.02% (3.11) Asym. Eff 2.96 (4.79) 2.51 (4.10) 2.07 (3.36) 1.83 (2.82) 1.15 (1.77)
EFD. The magnitude of returns following negative momentum is greater compared to returns following positive momentum. As shown in Table II, taking firm age proxy for example, following negative momentum, the return of the U5 portfolio is 1.62% lower than the return of the U1 portfolio; following positive momentum, the return of the U5 portfolio is only 0.12% higher than the return of the U1
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Figure 2. Positive and Negative Momentum Returns Under Uncertainty (12 1). The six panels show the post-formation 1-month returns across 5 uncertainty levels measured respectively by six proxies. The black lines in each panel represent post-formation 1-month returns following winner (upper quintile) pre-formation returns, which have mostly flat slopes. The grey lines represent post-formation 1-month returns following loser (lower quintile) pre-formation returns. The grey lines decline obviously across the uncertainty axis for all uncertainty proxies. This suggests a greater effect of negative momentum compared to positive momentum for portfolios with more uncertainty. The sample period is from January 1983 to December 2005.
portfolio. Furthermore, we compare the divergence of the returns following negative and positive momentum. Using the return of the U3 portfolio as a benchmark, we can see that the portfolio returns under negative momentum for each uncertainty level diverge more than under positive momentum. For example, as shown in Table II, for MV uncertainty proxy, the return of the U3 portfolio is 0.7% lower than the return of the U1 portfolio under negative momentum; under positive momentum, the difference is only 0.24%. This observation is mostly true for each uncertainty level and for all proxies. We obtain similar results for portfolios using 6 6 trading strategies (see Table III). Figure 2 illustrates the asymmetric
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Table III. Positive and Negative Momentum Returns and Asymmetric Effect (6 6) The table reports average annual portfolio returns from month t + 1 to t + 6 sorted by price momentum and uncertainty proxy. Each month we first sort stocks into five quintiles based on returns from months t 6 to t 1. For each momentum quintile, we further sort stocks into five groups based on uncertainty proxy. Firm size (MV) is the market capitalisation (in millions of dollars) at the end of month t. Firm age (AGE) is the number of years since the firm was first covered by CRSP. Analyst coverage (COV) is the number of analysts following the firm in the previous year. Earnings forecast dispersion (EFD) is the standard deviation of analyst forecasts in month t scaled by the prior year-end stock price. Stock volatility (SIGMA) is the standard deviation of weekly market excess returns over the year ending at the end of month t. Cash flow volatility (CVOL) is the standard deviation of cash flow from operations in the past 5 years (with a minimum of 3 years). Stocks are held for 6 months, and portfolio returns are equally weighted. The sample period is from January 1983 to December 2005; t-statistics in parentheses are adjusted for autocorrelation.
Uncertainty Proxy: MV Neg. U1 U2 U3 U4 U5 5.96% 3.67% 2.15% 0.73% 1.01% Pos. 12.29% 10.45% 9.99% 9.41% 7.38% Moment. 6.33% (4.81) 6.78% (4.99) 7.84% (5.59) 8.68% (6.02) 8.39% (6.26) Asym. Eff 18.25 (13.8) 14.12 (10.4) 12.14 (8.65) 10.14 (7.04) 6.38 (4.76) Neg. 5.34% 4.21% 2.72% 1.15% 1.96% Uncertainty Proxy: AGE Pos. 8.84% 10.00% 10.83% 10.39% 9.33% Moment. 3.50% (3.15) 5.80% (4.63) 8.12% (5.98) 9.24% (6.04) 11.29% (7.09) Asym. Eff 14.18 (12.7) 14.21 (11.3) 13.55 (9.98) 11.54 (7.55) 7.36 (4.63)
Uncertainty Proxy: SIGMA Neg. U1 U2 U3 U4 U5 5.17% 4.08% 2.82% 0.52% 0.68% Pos. 10.11% 10.61% 10.62% 9.89% 8.19% Moment. 4.94% (5.21) 6.53% (5.74) 7.80% (5.63) 9.37% (5.85) 8.87% (4.60) Asym. Eff 15.29 (16.1) 14.70 (12.9) 13.44 (9.70) 10.41 (6.50) 7.52 (3.90) Neg. 4.88% 4.48% 2.99% 1.92% 1.12%
Uncertainty Proxy: CVOL Pos. 8.90% 9.66% 10.58% 10.09% 9.84% Moment. 4.02% (3.72) 5.18% (4.20) 7.60% (5.60) 8.17% (5.09) 10.96% (5.62) Asym. Eff 13.78 (12.7) 14.14 (11.4) 13.57 (10.0) 12.00 (7.48) 8.71 (4.47)
Uncertainty Proxy: COV Neg. U1 U2 U3 U4 U5 4.19% 3.57% 2.72% 2.02% 0.61% Pos. 10.38% 9.95% 10.74% 11.08% 10.03% Moment. 6.19% (4.33) 6.38% (4.45) 8.02% (5.70) 9.06% (6.28) 9.43% (6.83) Asym. Eff 14.57 (10.1) 13.52 (9.43) 13.46 (9.56) 13.10 (9.08) 10.64 (7.71) Neg 5.02% 3.77% 3.36% 1.86% 0.54%
Uncertainty Proxy: EFD Pos. 14.86% 11.26% 9.65% 8.47% 7.61% Moment. 9.84% (6.71) 7.49% (5.30) 6.29% (4.48) 6.61% (4.46) 7.08% (4.53) Asym. Eff 19.88 (13.5) 15.03 (10.6) 13.02 (9.26) 10.33 (6.98) 8.15 (5.21)
momentum effects. For most uncertainty proxies, the dark line representing post formation returns following positive momentum is flatter than the grey line representing post formation returns following negative momentum across uncertainty levels. This implies greater price continuation following negative momentum than
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Figure 3. Asymmetry of the Momentum Returns Under Uncertainty. The figure shows the asymmetric effect of momentum returns, the sum of loser and winner postformation 1 month returns (left graph) and 6 months returns (right graph), across uncertainty levels for each uncertainty proxy. The downward sloped lines suggest that the reaction to negative momentum dominates the reaction to positive momentum for portfolios with higher level of uncertainty. The sample period is from January 1983 to December 2005.
following positive momentum for stocks with uncertainty. This effectively completes the test of Hypothesis 1. In order to test Hypothesis 2, we sum the returns following positive and negative momentum for each uncertainty level. If an increased uncertainty level has no impact on positive and negative momentum effects on portfolio returns, the sum of the returns should be similar across U1 to U5. In fact, we find that such a sum decreases with an increase in uncertainty associated with portfolios. As shown in Table II, following the two types of momentum, the portfolio with more uncertainty has lower sum of post returns than the portfolio with less uncertainty for all uncertainty proxies. For example, for the COV proxy, the sum of U5 portfolio return is 0.77% lower than the sum of U1 portfolio return. This implies that the effect of negative momentum dominates the effect of positive momentum more significantly with increasing uncertainty level associated with stocks. We obtain similar results for portfolios using 6-6 trading strategies (see Table III). Figure 3 plots the main results. The downward sloped curves suggest that asymmetric momentum effects become more profound with increasing uncertainty. To test Hypothesis 3, we split the sample period into two, crisis period and noncrisis period. We construct the crisis period as the sum of time length for two wellknown financial crises in the US stock markets, from September 1987 to January 1988 and from January 2000 to January 2003. The rest of the sample period between 1983 to 2005 forms the non-crisis period. We assume that there is higher market uncertainty concerning stocks in the crisis period than in the non-crisis period.
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The formation of the portfolio and the calculation of portfolio returns for two trading strategies are the same as before for each subperiod. Since the crisis period is relatively short, we test for 6 6 months strategy to obtain the results. We found that the portfolio returns are overall lower in the crisis period under both positive and negative momentum. Except for proxies MV and COV, positive momentum disappeared for portfolios with more uncertainty and negative momentum deepened with the increased uncertainty associated with the portfolio. Using proxy AGE for example, as shown in Table IV, while U5 portfolio return is 18.7% lower than U1 portfolio following negative momentum during crisis period, U5 portfolio return is 4.4% lower than the U1 portfolio following negative momentum during the noncrisis period. Following positive momentum, U5 portfolio return is negative and 2.3% lower than the U1 portfolio during the crisis period, U5 portfolio return is almost 1% higher than the U1 portfolio during the non-crisis period. Figure 4 illustrates that asymmetric patterns are more significant during the crisis period compared to the non-crisis period. Except proxies COV and MV, a steeper downward sloped curve for all other uncertainty proxies across uncertainty level for the measurement of asymmetry during crisis suggests that asymmetry between negative and positive momentum is more significant during the crisis compared to the non-crisis period. This confirms our Hypothesis 3.11
4.2 LIKELIHOOD OF PRICE CONTINUATION
In order to make sure that the results are not driven by extreme outliers, we perform a robustness check and test the hypothesis in a different way. We look for patterns by comparing the likelihood of price continuation for each individual stock by momentum and uncertainty proxy. If negative momentum has stronger effects on stock returns than positive momentum and asymmetry increases with an increase in uncertainty, we observe that price continuation is more likely following negative momentum than following positive momentum, especially for stocks with a high uncertainty level. In order to implement the approach, we define negative past average monthly returns rather than relative past return losers as negative momentum. We construct our hypothesis on the relationship between past returns (momentum) and post returns as the following 2 2 contingency table, Nnn = N ( Rt J ,t 1 < 0, Rt + K < 0), Nnp = N ( Rt J ,t 1 0, Rt + K 0), N pn = N ( Rt J ,t 1 0, Rt + K 0), N pp = N ( Rt J ,t 1 > 0, Rt + K > 0),
11 We found that both positive and negative momentum returns have downward slopes across uncertainty level during the crisis period. Specifically, the slope for portfolio returns following negative momentum during crisis period is steeper for all uncertainty proxies compared to the non-crisis period. This implies a even stronger reaction to negative momentum during the crisis period when markets general uncertainty level is higher.
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Table IV. Crisis vs. Non-Crisis: Momentum Returns and Asymmetric Effect (6 6) The table compares momentum returns during the crisis and the non-crisis periods. We define the crisis periods as combined periods from September 1987 to January 1988 and from January 2000 to January 2003. Non-crisis periods consist of all other complimentary months. For each month we first sort stocks into five quintiles based on returns from months t 6 to t 1. For each momentum quintile, we further sort stocks into five groups based on uncertainty proxy. Firm size (MV) is the market capitalisation (in millions of dollars) at the end of month t. Firm age (AGE) is the number of years since the firm was first covered by CRSP. Analyst coverage (COV) is the number of analysts following the firm in the previous year. Earnings forecast dispersion (EFD) is the standard deviation of analyst forecasts in month t scaled by the prior year-end stock price. Stock volatility (SIGMA) is the standard deviation of weekly market excess returns over the year ending at the end of month t. Cash flow volatility (CVOL) is the standard deviation of cash flow from operations in the past 5 years (with a minimum of 3 years). Stocks are held for 6 months, and portfolio returns are equally weighted. The sample period is from January 1983 to December 2005; t-statistics in parentheses are adjusted for autocorrelation.
Crisis Period Uncertainty Proxy: MV Neg. U1 U2 U3 U4 U5 Pos. Asym. Effect Neg. Uncertainty Proxy: AGE Pos. Asym. Effect Uncertainty Proxy: SIGMA Neg. Pos. Asym. Effect 14.95 (5.68) 5.88 (1.82) 1.34 (0.36) 11.4 (2.79) 24.8 (4.82)
4.35% 1.44% 5.13% 0.52% 3.85% 1.60% 4.77% 2.92% 4.98% 0.97%
5.79 (1.60) 2.89% 0.65% 3.54% (1.14) 5.88% 9.07% 4.61 (1.22) 1.40% 2.70% 1.30% (0.39) 1.17% 4.71% 2.26 (0.60) 2.53% 3.05% 0.52% (0.15) 3.50% 2.16% 1.85 (0.50) 6.05% 0.23% 6.28% (1.54) 9.60% 1.83% 4.01 (1.16) 15.8% 1.84% 17.7% (4.14) 15.3% 9.46% Uncertainty Proxy: COV Neg. Pos. Asym. Effect Neg.
Uncertainty Proxy: CVOL Neg. Pos. Asym. Effect
Uncertainty Proxy: EFD Pos. Asym. Effect 3.72 (1.00) 4.80 (1.30) 2.38 (0.63) 8.27 (1.98) 10.4 (2.37)
U1 0.67% 1.48% 4.44 (1.30) U2 1.14% 2.65% 0.71 (0.19) U3 0.37% 0.94% 1.24 (0.32) U4 0.13% 0.31% 6.40 (1.57) U5 2.16% 6.53% 19.6 (4.10)
8.63% 3.61% 12.2% (2.96) 3.49% 0.03% 3.52% (0.91) 3.28% 2.52% 0.76% (0.20) 3.43% 2.91% 0.52% (0.15) 4.30% 3.50% 0.80% (0.21) Non-Crisis Period
5.91% 2.19% 5.00% 0.20% 2.70% 0.32% 5.76% 2.51% 7.27% 3.20%
Uncertainty Proxy: MV Neg. U1 7.71% U2 5.16% U3 3.16% U4 1.67% U5 0.33% Pos. 14.61% 12.14% 11.41% 10.51% 8.47% Asym.Effect 22.32 (16.8) 17.30 (12.3) 14.58 (9.82) 12.18 (7.87) 8.14 (5.65) Neg.
Uncertainty Proxy: AGE Pos. 10.23% 11.24% 12.15% 12.19% 11.22% Asym. Effect 15.98% (13.6) 16.40% (12.3) 15.76% (10.8) 14.56% (9.04) 11.61% (7.09)
Uncertainty Proxy: SIGMA Neg. 5.05% 4.58% 3.89% 2.24% 1.82% Pos. 10.29% 11.61% 12.05% 11.88% 11.18% Asym. Effect 15.34 (15.0) 16.19 (13.4) 15.94 (10.8) 14.12 (8.38) 13.00 (6.59)
5.75% 5.16% 3.61% 2.37% 0.39%
(Continued )
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Table IV. Continued
Uncertainty Proxy: CVOL Neg. U1 U2 U3 U4 U5 5.21% 5.57% 3.86% 3.38% 0.91% Pos. 10.15% 10.85% 12.22% 11.75% 12.61% Asym. Effect 15.36 (13.9) 16.42 (12.8) 16.08 (11.3) 15.13 (8.85) 13.52 (6.59) Neg. 6.36% 4.76% 3.73% 2.94% 1.44% Uncertainty Proxy: COV Pos. 12.75% 11.64% 12.13% 12.46% 11.14% Asym. Effect 19.11% (13.4) 16.40% (10.9) 15.86% (10.6) 15.41% (9.87) 12.58% (8.60) Neg. 6.97% 5.34% 4.44% 3.22% 1.93%
D. KELSEY ET AL.
Uncertainty Proxy: EFD Pos. 17.12% 13.23% 11.32% 10.43% 9.45% Asym. Effect 24.10 (15.9) 18.57 (12.6) 15.77 (10.6) 13.66 (8.93) 11.38 (7.01)
Figure 4. Crisis vs. Non-Crisis: Asymmetry of Momentum Returns under Uncertainty (6 6). The figure compares the asymmetric effect of momentum returns during the crisis and the non-crisis periods. We define crisis periods as combined periods from September 1987 to January 1988 and from January 2000 to January 2003. Non-crisis periods consist of all other complimentary months. The measure of asymmetry is the sum of loser and winner post-formation 6 month returns across uncertainty levels for each uncertainty proxy. The downward sloped lines suggest that the reaction to negative momentum dominates the reaction to positive momentum for portfolios with higher level of uncertainty.
where N () stands for the number of stocks satisfying the corresponding condition. For example, the number of stocks with realisation that post return is negative following negative momentum (negative past return) is denoted by Nnn , the notations in the other three cells follow similarly.
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We firstly sort stocks into uncertainty quintiles for each uncertainty proxy. In each uncertainty quintile, we sort stocks into 2 groups by positive and negative average past J-month returns. We further classify stocks in each group into one of two categories based on positive and negative post K-month returns. This results in 20 groups of stocks for each uncertainty proxy. The number of stocks (firms) in each group is then counted and compared as shown in the contingency table. N , as the number of firms We define the ratio of positive momentum, r pp = Npp p which had positive post formation returns following positive pre-formation J-month return divided by the number of firms which had positive pre-formation returns. nn The ratio of negative momentum, rnn = N Nn , is similarly defined. Table V presents the main results for 12-1 trading strategy. Firstly, we found that the majority have positive returns in the past 12 months. This is consistent with classic asset pricing theories. However, following positive momentum, the number of firms having price continuation is decreasing with increased uncertainty across uncertainty quintile for all proxies. In comparison, following negative momentum, the number of firms having price continuation is increasing with increased uncertainty across uncertainty quintile for all proxies. Figure 5 illustrates the results. The black line representing r pp is downward sloped for all uncertainty proxies. This implies that stocks with more uncertainty are less likely to have positive returns following positive momentum than stocks with less uncertainty. In contrast, the dashed line representing rnn is upward sloping along the uncertainty axis for all proxies. It says that stocks with more uncertainty are more likely to have negative returns following negative momentum than stocks with less uncertainty. Similar results are obtained when using 6-6 strategy. We also applied similar analysis to the crisis period compared to the non-crisis period for 6 6 strategy (see Table VI and Figure 6). As shown in Figure 6, except for proxies COV and MV, the ratio r pp during the crisis period is lower and has a slightly steeper downward slope along the uncertainty axis compared to the ratio r pp during the non-crisis period. Meanwhile, the ratio rnn is in general greater and has a slightly steeper upward slope along the uncertainty axis compared to non-crisis period. In sum, the results of likelihood comparison between positive and negative momentum confirmed the greater negative momentum effects for stocks with more uncertainty including both idiosyncratic and market uncertainty. Some recent literature suggested that positive returns are more likely to continue than negative returns. For instance, Nam et al. (2001) and Nam et al. (2002) found that positive returns tend to persist longer than negative returns for the US stock market, and they concluded that momentum generally lasts longer for upward trends in the market. This paper suggested that this might not be true in some cases. For more uncertain firms, negative returns are more likely to continue, compared to positive returns. Our findings imply that the previous arguments on longer-lasting positive momentum could be limited to more mature stock markets where in general
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Table V. Proportions of Stocks with Positive Vs. Negative Returns (12 1)
D. KELSEY ET AL.
This table reports the likelihood of post-formation 1 month price continuation for each individual stock by uncertainty proxy. The subscript p means positive returns (positive price changes) and n means negative returns (negative price changes). N pp is a fraction of stocks which have positive post-formation return following positive pre-formation 12-months return, N pn is a fraction of stocks which have negative post-formation portfolio return following positive pre-formation returns. Nnn and Nnp are defined similarly. We define the ratio of positive momentum as r pp = N pp / N p and the ratio of negative momentum as rnn = Nnn / Nn . The ratio r pp is decreasing with increased uncertainty for all uncertainty proxies and the ratio rnn is increasing with increased uncertainty for all uncertainty proxies.
Uncertainty Proxy: MV Nnn U1 U2 U3 U4 U5 0.119 0.153 0.179 0.196 0.180 Nnp 0.152 0.183 0.201 0.203 0.179 N pn 0.307 0.289 0.278 0.274 0.295 N pp 0.422 0.375 0.342 0.328 0.347 rnn 0.439 0.455 0.472 0.491 0.501 r pp 0.579 0.565 0.551 0.544 0.540 Nnn 0.144 0.155 0.158 0.176 0.193 Uncertainty Proxy: AGE Nnp 0.176 0.181 0.181 0.186 0.193 N pn 0.294 0.296 0.290 0.286 0.277 N pp 0.386 0.369 0.370 0.352 0.336 rnn 0.450 0.461 0.467 0.486 0.500 r pp 0.568 0.555 0.560 0.552 0.548
Uncertainty Proxy: SIGMA Nnn U1 U2 U3 U4 U5 0.123 0.143 0.167 0.195 0.198 Nnp 0.160 0.176 0.193 0.203 0.185 N pn 0.281 0.291 0.284 0.281 0.306 N pp 0.435 0.390 0.355 0.321 0.311 rnn 0.434 0.449 0.465 0.490 0.516 r pp 0.608 0.573 0.556 0.533 0.504 Nnn 0.136 0.154 0.169 0.186 0.210
Uncertainty Proxy: CVOL Nnp 0.169 0.186 0.190 0.198 0.200 N pn 0.295 0.293 0.292 0.288 0.287 N pp 0.399 0.367 0.349 0.329 0.303 rnn 0.446 0.453 0.471 0.484 0.513 r pp 0.575 0.556 0.544 0.533 0.513
Uncertainty Proxy: COV Nnn U1 U2 U3 U4 U5 0.153 0.166 0.171 0.179 0.172 Nnp 0.183 0.195 0.192 0.193 0.183 N pn 0.289 0.283 0.284 0.281 0.288 N pp 0.375 0.357 0.352 0.347 0.358 rnn 0.455 0.459 0.471 0.482 0.484 r pp 0.565 0.558 0.553 0.553 0.554 Nnn 0.110 0.140 0.166 0.198 0.247
Uncertainty Proxy: EFD Nnp 0.143 0.172 0.195 0.219 0.248 N pn 0.316 0.303 0.284 0.266 0.237 N pp 0.432 0.385 0.356 0.317 0.268 rnn 0.435 0.449 0.459 0.475 0.498 r pp 0.577 0.560 0.556 0.544 0.531
the uncertainty level is comparably low. For emerging markets such as the China stock market, the uncertainty level might be prevailingly high across stocks. The implication of our findings suggest that the downward trend might last longer in the market. The real observations of Chinese stock markets support this argument. For instance, Yan et al. (2007) found that the China stock market is characterised mostly as a bear market from 2001 to 2005, with only two short lived bull markets
25
Figure 5. Likelihoods of Momentum vs. Reversal (12 1). This figure presents the likelihoods of post-formation 1 month price continuation for each individual stock by uncertainty proxy. We define the ratio of positive momentum, r pp = N pp / N p , as the number of stocks with positive post-formation return following positive pre-formation 12-months return divided by the number of stocks with positive pre-formation returns. The ratio of negative momentum, rnn = Nnn / Nn , is similarly defined. The dashed lines represent the ratio rnn , which is increasing with uncertainty and the solid black lines represent the ratio r pp , which is decreasing along the uncertainty axis.
lasting only six months each during these four years. (See Table I on page 237 in Yan et al. (2007).)
5. Concluding Remarks
This paper studies asymmetric momentum effects under uncertainty. Using the US stock market and accounting data, we have identified that negative momentum is
26
D. KELSEY ET AL.
Table VI. Crisis vs. Non-Crisis: Proportions of Stocks with Positive and Negative Returns This table compares the likelihoods of post-formation 6-month price continuation for each individual stock by uncertainty proxy for the crisis and the non-crisis periods. We define crisis periods as combined periods from September 1987 to January 1988 and from January 2000 to January 2003. Non-crisis periods consist of all other complimentary months. The subscript p means positive returns (positive price changes) and n means negative returns (negative price changes). We define the ratio of positive momentum, r pp = N pp / N p , as the number of stocks with positive post-formation return following positive pre-formation 6-months return divided by the number of stocks with positive preformation returns. Similarly, the ratio of negative momentum, rnn = Nnn / Nn , is the number of stocks with negative post-formation returns following negative pre-formation 6-month returns divided by the number of stocks with negative pre-formation returns. r pp is decreasing with increased uncertainty for all uncertainty proxies and rnn is increasing with increased uncertainty for all uncertainty proxies.
Crisis Period MV rnn U1 U2 U3 U4 U5 0.453 0.462 0.479 0.482 0.452 r pp 0.477 0.494 0.507 0.544 0.594 rnn 0.394 0.423 0.458 0.495 0.551 AGE r pp 0.515 0.531 0.533 0.527 0.524 SIGMA rnn 0.299 0.372 0.424 0.525 0.645 r pp 0.707 0.601 0.519 0.432 0.322 CVOL rnn 0.390 0.431 0.487 0.532 0.621 r pp 0.524 0.495 0.465 0.425 0.336 rnn 0.496 0.461 0.483 0.465 0.447 COV r pp 0.454 0.468 0.512 0.524 0.571 rnn 0.449 0.457 0.453 0.485 0.536 EFD r pp 0.518 0.493 0.477 0.458 0.432
U1 U2 U3 U4 U5
0.346 0.410 0.456 0.499 0.531
0.676 0.622 0.584 0.558 0.538
0.392 0.425 0.449 0.482 0.514
0.642 0.605 0.601 0.581 0.558
0.395 0.403 0.439 0.479 0.532
Non-Crisis Period 0.691 0.389 0.640 0.409 0.600 0.446 0.546 0.481 0.497 0.532
0.653 0.605 0.577 0.552 0.502
0.389 0.427 0.448 0.470 0.474
0.646 0.608 0.595 0.588 0.582
0.361 0.388 0.415 0.447 0.497
0.677 0.634 0.611 0.590 0.549
greater than positive momentum in terms of both magnitude and persistency of portfolio returns. Such asymmetric patterns are determined by the level of uncertainty associated with stocks including both idiosyncratic and market uncertainty. We find that, compared to stocks with less uncertainty, negative momentum has greater effects than positive momentum for stocks with greater uncertainty. We also find such asymmetry is more profound in the US stock market during more uncertain periods. We suggest that such asymmetry can be explored in trading strategy. For stocks with greater uncertainty, buying winners and selling losers might not be the optimal way to generate profit. More profit can be realised through short selling losers following negative momentum than through buying winners.12 Therefore an optimal investment weight might exist in a more profitable momentum trading strategy.
12
Hong et al. (2000) suggested LAST trading strategy which is in line with the implications here.
27
Figure 6. Crisis vs. Non-Crisis: Likelihoods of Momentum vs. Reversal. This figure compares the likelihoods of post-formation 6-months price continuation for each individual stock by uncertainty proxy for the crisis and the non-crisis periods. We define crisis periods as combined periods from September 1987 to January 1988 and from January 2000 to January 2003. Non-crisis periods consist of all other complimentary months. The solid lines represent the ratio of positive momentum, r pp = N pp / N p , defined as the number of stocks with positive post-formation return following positive pre-formation 6-months return divided by the number of stocks with positive pre-formation returns. The dashed lines represent the ratio of negative momentum, rnn = Nnn / Nn , defined as the number of stocks with negative post-formation returns following negative pre-formation 6-month returns divided by the number of stocks with negative pre-formation returns. The grey lines correspond to the crisis period and the black lines represent non-crisis period.
We also hope that our findings here provide support to the literature suggesting uncertainty as an alternative source for the phenomena of price continuation.13 Well established arguments including underreaction theory and overreaction theory do not explain completely the findings here. First, there is no explicit explanation that
13
Ford et al. (2006) suggested that uncertainty can be the cause of momentum trading.
28
D. KELSEY ET AL.
overreaction and under-reaction should be greater when information is negative14 . Second, while the overreaction argument explained mean reversing patterns, it can not explain why, for firms with more uncertainty, negative momentum returns are more likely to continue than positive momentum returns. Meanwhile, for stocks with less uncertainty, negative momentum returns are more likely to reverse than positive momentum returns. We hope that our investigation on the role of uncertainty in this paper provides a new angle to study momentum trading.
References
Andersen, T., Bollerslev, T., Diebold, F., and Vega, C. (2007) Real-time price discovery in stock, bond and foreign exchange markets, Journal of International Economics. Barberis, N., Shleifer, A., and Vishny, R. (1998) A model of investor sentiment, Journal of Financial Economics 49, 307343. Beber, A. and Brandt, M. (2009) When it cannot get better or worse: The asymmetric impact of good and bad news on bond returns in expansions and recessions, Review of Finance pp. 137. Camerer, C. F. and Weber, M. W. (1992) Recent Developments in Modelling Preferences: Uncertainty and Ambiguity, Journal of Risk and Uncertainty 5, 32570. Chan, L., Jegadeesh, N., and Lakonishok, J. (1996) Momentum strategies, Journal of Finance 51, 16811714. Chan, W. F. (2003) Stock price reaction to news and no-news: Drift and reversal after headlines, Journal of Financial Economics 70, 223260. Daniel, K., Hirshleifer, D., and Subrahmanyam, A. (1998) Investor psychology and security market under and over-reactions, Journal of Finance 53, 18391885. De Long, B., Shleifer, A., Summers, L., and Waldmann, J. (1990) Positive feedback investment strategies and destabilizing rational speculation, Journal of Finance 45, 379395. Ellsberg, D. (1961) Risk, ambiguity, and the savage axioms, Quarterly Journal of Economics 75, 643669. Epstein, L. and Schneider, M. (2008) Ambiguity, information quality and asset pricing, Journal of Finance 63, 197228. Ford, J., Kelsey, D., and Pang, W. (2006) Information and ambiguity: Herd and contrarian behaviour in financial markets, Economics Discussion Paper, University of Birmingham, UK. Garlappi, L., Uppal, R., and Wang, T. (2007) Portfolio selection with parameter and model uncertainty: A multi-prior approach, Review of Financial Studies 20, 4181. Gilboa, I. and Schmeidler, D. (1989) Maxmin expected utility with non-unique prior, Journal of Mathematical Economics 18, 141153. Hong, H., Lim, T., and Stein, J. (2000) Bad news travel slowly: Size, analyst coverage, and the profitability of momentum strategies, Journal of Finance 55, 265295. Hong, H. and Stein, J. (1999) A unified theory of underreaction, momentum trading and overreaction in asset markets, Journal of Finance 54, 21432184. Jegadeesh, N. and Titman, S. (1993) Returns to buying winners and selling losers: Implications for stock market efficiency, Journal of Finance 48, 6591.
14
With exception, Hong et al. (2000) suggested that greater underreaction is attributed to slowly dispensing speed of bad news by using firm size and analyst coverage proxies.
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Lee, C. and Swaminathan, B. (2000) Price momentum and trading volume, Journal of Finance 55, 20172069. Moskowitz, T. and Grinblatt, M. (1999) Do industries explain momentum? Journal of Finance 54, 12491290. Nam, K., Pyun, C., and Arize, A. (2002) Asymmetric mean-reversion and contrarian profits: ANSTGARCH approach, Journal of Empirical Finance 9, 563588. Nam, K., Pyun, C., and Avard, S. (2001) Asymmetric reverting behaviour of shorthorizon stock returns: An evidence of stock market overreaction, Journal of Banking and Finance 25, 807824. Rouwenhorst, K. (1998) International momentum strategies, Journal of Finance 53, 267284. Yan, W., Powell, J., Shi, J., and Xu, W. (2007) Chinese stock market cyclical regimes: 19912006, Economics Letters 97, 235239. Zhang, F. (2006) Information uncertainty and stock returns, Journal of Finance 61, 105137.

Asymmetric Momentum Effect Under Uncertainty

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Review of Finance (2010), 129 doi: 10.

Asymmetric Momentum Effects Under Uncertainty

DAVID KELSEY1 , ROMAN KOZHAN2 and WEI PANG3

University of Exeter; 2 University of Warwick; 3 Kingston University

ASYMMETRIC MOMENTUM UNDER UNCERTAINTY

ASYMMETRIC MOMENTUM UNDER UNCERTAINTY

ASYMMETRIC MOMENTUM UNDER UNCERTAINTY

Demands of two other traders types are

which increases with the strength of the relative signal .

ASYMMETRIC MOMENTUM UNDER UNCERTAINTY

ASYMMETRIC MOMENTUM UNDER UNCERTAINTY

3. Data and Methodology

Rt +6 Rt +1 Rt +6 Rt 12,t 1 Rt 6,t 1 MV AGE SIG CVOL COV 0.374 1

Rt 12,t 1 0.006 0.002 1

Rt 6,t 1 0.011 0.024 0.695 1

CVOL 0.004 0.010 0.066 0.051 0.002 0.017 0.097 1

COV 0.000 0.001 0.029 0.033 0.316 0.329 0.044 0.083 1

ASYMMETRIC MOMENTUM UNDER UNCERTAINTY

ASYMMETRIC MOMENTUM UNDER UNCERTAINTY

ASYMMETRIC MOMENTUM UNDER UNCERTAINTY

ASYMMETRIC MOMENTUM UNDER UNCERTAINTY

Uncertainty Proxy: CVOL Neg. Pos. Asym. Effect

5.75% 5.16% 3.61% 2.37% 0.39%

ASYMMETRIC MOMENTUM UNDER UNCERTAINTY

ASYMMETRIC MOMENTUM UNDER UNCERTAINTY

0.346 0.410 0.456 0.499 0.531

0.676 0.622 0.584 0.558 0.538

0.392 0.425 0.449 0.482 0.514

0.642 0.605 0.601 0.581 0.558

0.395 0.403 0.439 0.479 0.532

0.653 0.605 0.577 0.552 0.502

0.389 0.427 0.448 0.470 0.474

0.646 0.608 0.595 0.588 0.582

0.361 0.388 0.415 0.447 0.497

0.677 0.634 0.611 0.590 0.549

ASYMMETRIC MOMENTUM UNDER UNCERTAINTY

ASYMMETRIC MOMENTUM UNDER UNCERTAINTY

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