Abstract
We analyze a novel alpha momentum strategy that invests in stocks based on three-factor alphas. In contrast to the common price momentum strategy, our ranking accounts only for this stock-specific component which we estimate using daily returns. The empirical analysis for the U.S. and for Europe shows that i) past alpha has power in predicting the cross-section of stock returns, ii) alpha momentum exhibits less dynamic factor exposures than price momentum and iii) alpha momentum dominates price momentum only in the U.S. Connecting both strategies to behavioral explanations, alpha momentum is more related to an underreaction to firm-specific news while price momentum is primarily driven by price overshooting due to momentum trading. In addition, both strategies are more profitable following periods of optimistic sentiment which can be explained by impediments to the short-selling of loser stocks in the U.S. and by increased momentum trading in winner stocks in Europe.
Highlights
The price momentum effect is one of the most widely studied phenomena in financial research
Our results indicate that past alpha has power in predicting the cross-section of individual stock returns in the U.S In contrast, European results reveal that both past alpha and past return are related to future returns
This paper contributes to the literature on the phenomenon of momentum by comparing the common price momentum strategy of Jegadeesh and Titman (1993) to a novel alpha momentum strategy that ranks stocks on three-factor alphas estimated based on daily returns
Summary
The price momentum effect is one of the most widely studied phenomena in financial research. When we look at a momentum strategy using only a subset of stocks that are in the winner or loser deciles based on their past alpha, but not based on their past return, we see that the performance of this strategy reverses only moderately in the U.S while it becomes flat in Europe over 60 months This pattern could be predominantly due to an underreaction to firm-specific news. To estimate the FF alphas of the momentum strategies, we first employ a Fama and French (1993) three-factor regression according to Equation (1) but use the return of the zero-investment portfolio in month t instead of the individual stock excess return ri,t In doing so, this unconditional model assumes constant factor exposures over time.
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