Momentum investing across economic states: evidence of market inefficiency in good times

Abstract

Hammami (2011) contends that excessive optimism and overconfidence arise naturally in good times when the economy is strong. This implies that market inefficiency might occur principally in good times. To examine this hypothesis, we investigate the momentum strategy (buying recent winners and selling recent losers) across economic states. We find that the profitability of the momentum strategy in the US stock market appears only in periods in which the expected market risk premium is low (good times). Traditional explanations based on seasonal effects or systematic risk do not account for the abnormal returns generated by momentum investing in good times. Alternatively, we discover that the profitability of the momentum strategy disappears in the post-1993 sample (following the discovery of momentum), which is consistent with the view that if momentum is an anomaly, then it will not appear in future data. These findings are viewed as evidence that the momentum anomaly is a market inefficiency, which has appeared especially in good times.

Keywords:

• momentum anomaly
• market efficiency
• market inefficiency
• asset pricing

JEL Classification::

• G10
• G12
• G14

Notes

¹ http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

² http://www.econ.yale.edu/~shiller/data.htm