Momentum investing with moving averages in the U.S. stock market
1University of Oulu, Oulu Business School, Department of Finance, Finance
|Online Access:||PDF Full Text (PDF, 0.6 MB)|
|Persistent link:|| http://urn.fi/URN:NBN:fi:oulu-201605121716
|Publish Date:|| 2016-05-13
|Thesis type:||Master's thesis
Momentum phenomenon has been one of the hardest market anomaly to be explained by the efficient market hypothesis and the risk based theories. The more recent behavioral theories offer much better explanations for this phenomenon. It is suggested that the investor’s over- and underreaction is the key element that generates momentum phenomenon and its profits. Momentum investment strategy is often seen as a method of technical analysis because it focuses on stock price trends and not to company fundamentals. In addition, there are clear similarities between momentum investing and moving average strategy. Both strategies can be seen as a trend-following strategies, so the simultaneous use of these strategies is justified.
The target of this thesis is to study if the simultaneous use of moving averages and momentum strategy is economically and statistically viable. In addition, the study investigates if the momentum strategy has been profitable in late 20th and early 21st century and have the recent market crashes affected the profits. As the research shows, the phenomenon is present in the late 20th and early 21st century but the strategy’s profits are lower than the earlier literature suggests. One main reason for this finding is the market sensitivity of momentum strategy. This research presents the evidence that the momentum profits are clearly linked to market states and the strategy loses its profitability during the negative market trends. This finding is supported by earlier literature. To overcome this, the study applies moving averages to the momentum strategy to try to time the markets.
The previous financial literature have shown that the moving averages have some ability to predict the changing market trends. This study presents more mixed results. It seems that the moving averages can indeed predict positive market trends but cannot predict market crashes. This thesis suggest that the reason for this finding is the severe and relatively short market crashes of the 21st century. In other words, the moving averages are able to recognize more long lasting trends than rapid market movements. The use of moving averages did lower the volatility of the used strategy but did not increase the profits.
This research uses average monthly returns to study the momentum effect with 3, 6, 9 and 12 month momentum strategies. S&P 500 Composite Index’s 12 month lagged market returns are used to define the market states. In addition, the moving averages strategy uses similar 3, 6, 9 and 12 month strategies with the momentum portfolios to study the market timing ability. The study focuses on the U.S. stock markets, and for this reason, the data in use is random sample of New York Stock Exchange listed companies, which includes 820 company stocks. The study period is from January 1995 to September 2013.
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