Market Cycles and the Performance of Relative Strength Strategies

• Author: Licheng Sun,Chris Stivers
• DOI: http://doi.org/10.1111/fima.12001
• Published date: 01 June 2013
• Date: 01 June 2013

Market Cycles and the Performance

of Relative Strength Strategies

Chris Stivers and Licheng Sun∗

We study the effect of market cycles on both medium-run and long-run relative strength trading

strategies. We find that payoffs for both strategies tend to be relatively higher within a market

state (rising or falling markets), but substantially lower over transitions between states. Since

shorter duration strategiesare relatively less likely to include market transitions, our results help

reconcile the puzzling fact that medium-run strategies are profitable, but long-run strategies are

not. We find that the market’s cross-sectional return dispersion: 1) tends to be higher around

market transitions,and 2) is negatively related to the subsequent payoffs for both medium-run and

long-run strategies.

The profitability suggested by simple relative strength strategies has generated much interest

in the recent literature and has important theoretical and practical implications. Jegadeesh and

Titman (1993) document that overperiods of 3 to 12 months, past winners tend to outperfor m past

losers. Recent empirical evidence suggests that these medium-run momentum profits persist in the

1990s, are present in both large-cap and small-cap stocks, and exist in a number of international

markets.1Curiously, in contrast to medium-run strategies, longer-run strategies tend to exhibit

reversals, where past losers tend to outperform past winners.2

In this paper, we study the implications of market cycles on relative strength strategies at both

the medium-run and longer-run horizons. Our focus is on a better understanding of: 1) the joint

time-series behavior of both medium-run and longer-run strategy payoffsand 2) the horizon-based

contrast in average relative strength payoffs where medium-run strategies have higher average

We thank an anonymous referee, Bob Connolly, Jennifer Conrad, Mike Cooper, Ro Gutierrez, Marc Lipson (Editor),

John Scruggs, Savannah Short, Jeff Wongchoti, Yexiao Xu, Sterling Yan, Jonathan Albert, and seminar participants at

the University of Georgia, the University of Missouri, the College of William and Mary, Florida State University, Old

Dominion University, the Federal Reserve Bank of Atlanta, and the Financial Management Association and Southern

Economic Association meetings for comments. Earlier drafts were presented under the title “Momentum Profits when

Mean Stock Returns Vary across Economic Regimes.”

∗Chris Stivers is a Professor of Finance at the University of Louisville in Louisville, KY. Licheng Sun is an Associate

Professor of Financeat Old Dominion University in Norfolk, VA.

1See Jegadeesh and Titman (2001), Fama and French (2008),R ouwenhorst (1998), and Griffin, Ji, and Martin (2003).

The profitability of medium-run momentum has survived risk-adjustments by the capital asset pricing model (CAPM)

and Fama-French three-factor asset pricing models (Fama and French,1996; Gr undy and Martin, 2001). This apparent

shortcoming of risk-based asset pricing has led to several interesting behavioralmodels that may generate momentum; see,

e.g., Daniel, Hirshleifer, and Subrahmanyam (1998) and Hong and Stein (1999), where overconfidence and momentum

traders are featured, respectively. More recent papers, with alternate approaches, present evidence that risk may be

importantly tied to momentum profits (Ahn, Conrad, and Dittmar, 2003; Liu and Zhang, 2008; Agarwal and Taffler,

2008).

2See DeBondt and Thaler (1985) and Conrad and Kaul (1998) for evidence regarding longer-run strategies. We use the

term “relative strength” strategies, rather than momentum, as a more general term that encompasses both the medium-run

momentum horizon and the longer-run reversal horizon.

Financial Management •Summer 2013 •pages 263 - 290

264 Financial Management rSummer 2013

profits and longer-run strategies have lower average profits, as compared to those suggested

solely by the cross-sectional variation of unconditional mean returns.

A few earlier studies haveconsidered the possibility that market cycles or market states may play

a role in understanding relative strength strategies. However, these recent studies have focused

solely on medium-term momentum and their market-state empirical approach, evidence, and

interpretation are appreciably different than ours.

Cooper, Gutierrez, and Hameed (2004) present evidence that momentum profits depend upon

the state of the market. Average momentum profits, using a lagged six-month ranking period,

are appreciably positive (marginally negative) following an up (down) market state, defined

as a nonnegative (negative) lagged 36-month market return. Cooper et al. (2004) argue that if

overconfidence is higher following market increases, then their findings are consistent with the

overconfidence behavioral model of Daniel, Hirshleifer,and Subrahmanyam (1998). Cooper et al.

(2004) conclude that “models of asset pricing, both rational and behavioral, need to incorporate

(or predict) such regime switches.”

Asem and Tian (2010) find that momentum profits are higher when markets stay in the same

state (either up or down) and lower for market transitions. Their interpretation also appeals to

Daniel et al. (1998), with the assumption of greater overconfidence for both up-state and down-

state continuations. Asem and Tian (2010) use: 1) a lagged six-month ranking period, 2) the

lagged 12-month market return to categorize the state, and 3) the subsequent one-month market

return and one-month momentum profit to assess market continuations and momentum.

Sagi and Seasholes (2007) introduce a rational model where the documented correlation be-

tween market states and momentum may be explained bya f irm’s growth options. In their model,

during up markets, firms tend to move closer to exercising their growth options, which tends to

increase return autocorrelations (and, hence, momentum). During down markets, firms tend to

move closer to financial distress, which tends to decrease return autocorrelations (and, as such,

momentum). They provide supportive simulated evidence.3

Grundy and Martin’s (2001) focus is not on market cycles, but they recognize that the market

trend over the ranking period should result in dynamic factor loadings for momentum strategies.

For ranking periods over an up-market, they note that momentum strategies should tend to place

a positive “market-beta bet” as the past relative winners should tend to have higher betas. They

analyze a momentum strategy with a lagged six-month ranking period and a subsequent one-

month holding period, and find that the strategy’s risk-adjusted performance improves when

they take into account the dynamic factor loadings. The dynamic factor loadings suggest that

transitions between market up and down states are likely to be associated with lower momentum

payoffs, a notion that we explore further in our study.

Our study begins by providing a simple statistical decomposition of relative strength profits

in a two-state market, with the goal of providing intuition and helping to frame our empirical

investigation. Our notion of “up-state means” and “down-statemeans” refers to the realized mean

stock return over a sizable but modest market period, such as several months to several years,

where the realized means are associated with changing economic conditions. Consider that both

Fama and French (1989) and Zhang (2005) arguethat the market’s price of risk is countercyclical,

with weak economic conditions associated with a higher risk premium. If so, then transitions to

3Chordia and Shivakumar (2002) find that momentum profits may be linked to business cycles and predicted by lagged

macroeconomic variables. However, Cooper et al. (2004) find that the results of Chordia and Shivakumar (2002) are

not robust to widely used methodological adjustments that guard against market frictions and penny stocks driving the

results. Further, Griffin et al. (2003) determine that the Chordia and Shivakumar (2002) results do not generally hold in

other countries. For other perspectives, see Grinblatt and Han (2005) and Hur,Pritamani, and Sharma (2010), who link

momentum to the disposition effect, and Loh (2010), who suggests investorinattention may induce momentum.