A tale of two states: asymmetries in the UK small, value and momentum premiums

ABSTRACT

This article performs comparative analysis of the asymmetries in size, value and momentum premium and their macroeconomic determinants over the UK economic cycles, using Markov switching approach. We associate Markov switching regime 1 with economic upturn and regime 2 with economic downturn. We find clear evidence of cyclical variations in the three premiums, most notable being that in the size premium, which changes from positive in expansions to negative in recessions. Macroeconomic indicators prompting such cyclicality the most are variables that proxy credit market conditions, namely the interest rates, term structure and credit spread. Overall, macro factors tend to have more significant impact on the three premiums during economic downturns. The results are robust to the choice of information variable used in modelling transition probabilities of the two-stage Markov switching model. We show that exploiting cyclicality in premiums proves particularly profitable for portfolios featuring small cap stocks in recessions at a feasible level of transaction costs.

KEYWORDS:

• Size
• value and momentum premiums
• two-state Markov switching model
• macroeconomic determinants
• cyclicality

JEL CLASSIFICATION:

• G11
• E32

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ The Investment Association Annual Survey ‘Asset Management in the UK’ available from: http://www.theinvestmentassociation.org//assets/files/research/2015/20150914-ams2014-2015-fullsurvey.pdf.

² Downloadable from: http://business-school.exeter.ac.uk/research/areas/centres/xfi/research/famafrench/files/ (Accessed on 20/07/2015).

³ The prior return at the end of month t is the cumulative return from month t − 12 to month t − 2. January is excluded from the calculation to adjust for the seasonal anomalies.

⁴ Note that the high-yield corporate bond data are not available for the UK market a period longer than 11 years. To cover longer span of varying economic regimes, we resort to Moody’s US BAA corporate bond index as a proxy for the UK data. The correlation coefficient Thomson Reuter UK Corporate Benchmark BBB (available since April 2002) and Moody’s US BAA is 0.871085 over the 11-year period.

⁵ See, Hamilton (1988), Hamilton (1994), Kim and Nelson (1999) and Jeanne and Masson (2000).

⁶ http://www.oecd.org/std/compositeleadingindicatorsclifrequentlyaskedquestionsfaqs.htm.

⁷ As defined by OECD’s Composite Leading Indicator (CLI) described in ‘Econometric framework for Markov switching model’ of the article.

⁸ Note that the conclusion regarding limits to arbitrage relates to transaction costs only. Presence of higher idiosyncratic risk and noise trading remains to be tested in future research.