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Irrational Pessimism? Examining Trading Volume and Market Momentum

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In an article in the October 2000 issue of the Journal of Finance, Charles M.C. Lee and Bhaskaran Swaminathan presented their findings on a study examining whether past returns and past trading volumes had predictive value in terms of future returns. One of their main conclusions was that the market overacts.

Lee and Swamintahan also concluded from their study that past trading volume provided an important link between momentum and value strategies. Here are some of their findings:

  • Stocks that had high trading activity exhibited growth characteristics, earned lower future returns, and consistently had more negative earnings surprises. One way to think of this is that these glamour stocks were “priced to perfection,” something that is rarely achieved. The distressed value stocks, on the other hand, had already discounted virtually all the bad news that might occur. They were, therefore, more likely to produce upside earnings surprises.
  • Past trading volumes also predicted the magnitude and persistence of the price momentum.
  • Price momentum effects are reversed over the next five years.
  • High volume winners experience the fastest reversals. The study also found that low volume stocks display many characteristics of value companies. They found that low volume stocks are associated with:
              -worse current operating performance
              -larger declines in past operating performance
              -higher book-to-market values
              -smaller number of analysts following the stock
             - lower long-term earnings estimates
              -lower stock returns over previous five years

What the authors of the study demonstrated was that those stocks that are rising tend to continue to rise over the short term. However, over the intermediate term they experience a reversal. The stocks that have risen the most on the most trading volume tend to experience the fastest and sharpest reversals. The stocks that experience these spikes and collapse tend to be growth stocks.

What should investors do with this information? In my opinion, nothing, except be aware of it. First, what makes the Efficient Markets Hypothesis the most powerful of economic theories is that once anomalies are discovered, the act of exploiting them will cause them to disappear. For example, if a January effect for small-cap stocks was discovered, then investors would start to buy them in December, but others knowing that would start to buy in November to beat the first group to the punch, and so on . . . you get the picture.

Just as stocks appear to exhibit momentum, it appears that asset classes may also exhibit this characteristic. With this in mind, remember that an investor practicing a regimen of regular rebalancing is already capturing both the momentum effect and the reversion to the mean. They are doing so without having to guess when the momentum ends and the reversion begins. Rebalancing allows investors to capture at least some of the momentum and reversion effects. The selling at the tops and the buying at the bottoms of the established tolerance bands allows investors to capture the reversion to the mean. In addition, and in my opinion most importantly, rebalancing keeps an investor’s risk profile in line with his or her investment policy statement.

One other point I would like to make in light of the “Internut” frenzy is that the study found that reversion to the mean happens with a vengeance to the stocks that experience the most explosive growth. If you ever need a reminder, just look at what happened to the once red-hot tech sector that got slaughtered in 2000.

03/23/2001

Larry Swedroe is the author of The Only Guide To A Winning Investment Strategy You Will Ever Need and What Wall Street Doesn't Want You to Know. He is also the Director of Research and Principal for Buckingham Asset Management, Inc. in St. Louis, Missouri. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management.