Momentum: The Technical Analysis Anomaly
Technical analysis, or charting, has a long history in finance. In this chapter, we take an in-depth look at some of the numerous academic studies completed over the past century that have investigated the profitability of various trading strategies based on past price patterns. As we will find out, the general consensus among these past studies is that two interesting patterns in stock returns tend to surface from the data over time: short-term to medium-term momentum, and long-term reversals. Momentum in stock returns is generally described as the continuation of those stocks that have performed well recently to do well over the subsequent 1–12 months. On the contrary, long-term reversals refer to the pattern of winning (loser) stocks tending to become losers (winners) in the long run, usually 3–5 years.
Readers of the chapter who are traders will be happy to learn that hedge portfolios based on short-term and medium-term momentum generate average returns of about 1% per month, or 12% annually. To arrive at this return estimate, researchers use past return data to simply sort stocks into deciles based on their recent return performance (typically measured over the prior 6 months) and then assess the relative performance of these decile portfolios over a subsequent holding period, ranging anywhere from one to twelve months. In summary, most past studies reveal that the top decile portfolio (the set of stocks that ...