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Studies on the Momentum Effect in the Uk Stock Market STUDIES ON THE MOMENTUM EFFECT IN THE UK STOCK MARKET by Jia Cao A Thesis Submitted in Fulfilment of the Requirements for the Degree of Doctor of Philosophy of Cardiff University Economics Section, Cardiff Business School, Cardiff University September 2014 DECLARATION This work has not previously been accepted in substance for any degree and is not concurrently submitted in candidature for any degree. Signed …………………………………………………………. (candidate) Date ………………………… STATEMENT 1 This thesis is being submitted in partial fulfilment of the requirements for the degree of …………………………(insert MCh, Md, MPhil, PhD etc, as appropriate) Signed …………………………………………………………. (candidate) Date ………………………… STATEMENT 2 This thesis is the result of my own independent work/investigation, except where otherwise stated. Other sources are acknowledged by footnotes giving explicit references. Signed …………………………………………………………. (candidate) Date ………………………… STATEMENT 3 I hereby give consent for my thesis, if accepted, to be available for photocopying and for inter-library loan, and for the title and summary to be made available to outside organisations. Signed …………………………………………………………. (candidate) Date ………………………… ABSTRACT This thesis studies the momentum effect in the UK stock market. The momentum effect is found to be a persistent yet not fully stable phenomenon in the UK stock market and its dynamics is at least partially conditional on the stability of the stock market. When the stock market is stable, momentum trading strategies tend to have rather reliable and good performances whereas when the stock market is in turmoil, momentum trading strategies tend to suffer losses in the near future. We construct a threshold regression model to analyse this relationship between the momentum effect and the stock market stability. We propose that there are two regimes in the short run for shares that have had extreme past performances, the momentum and the reversal regime, and that the switch from one regime to the other is governed by the stock market volatility. Our estimation results confirm this significant role of the stock market volatility. Moreover, the stock market volatility has a negative impact on a momentum trading strategy’s return in both regimes in most cases. Apart from the stock market volatility, we also find that a momentum portfolio’s ranking period return has a significant inverse relationship with its holding period return in the momentum regime, i.e., the magnitude of the momentum effect during its holding period. This negative relationship suggests that the reversal can occur in the short term even in the momentum regime when the ranking period return is sufficiently large. A new type of trading strategies is designed to take advantage of the predictability of the momentum effect dynamics, in particular, the switch between the momentum and the reversal, and our results show that they outperform momentum trading strategies with higher returns and lower risks. Indeed, following the indication of the threshold regression model, these new trading strategies can exploit not only the momentum effect but also the contrarian effect. More importantly, they are able to generate economically significant profits net of transaction costs even when momentum trading strategies fail to do so. The predictability of the dynamics of the momentum effect and the superior performance of our new trading strategies create an even bigger anomaly than the momentum effect itself in the stock market. I ACKNOWLEDGEMENT Completing a five-year PhD programme is an enduring race and this doctoral thesis for me is a tremendous achievement. All of these would not have been possible without the help, encouragement and support of many kind people around me. First, I would like to express my deepest gratitude to my supervisor, Professor Laurence Copeland, for his excellent guidance, invaluable advice and incredible patience. His passion and dedication in financial research is inspirational for me. No matter how tedious or challenging the work is, it becomes pleasant with him. I would like to give my sincere appreciation to Professor Patrick Minford for giving me one of the most precious opportunities in my life to conduct this postgraduate doctoral research in Cardiff Business School. I also thank him for his constructive comments on my thesis at workshops. My special appreciation goes to Dr Guangjie Li for his expert help and illuminating explanation of Bayesian estimation method. I shall never forget his kindness, and his willingness to offer helps. I would like to thank Professor Kent Matthews, Dr Woon Wong, Dr Helmuts Azacis, Dr Zhirong Ou, and many others in Economics Section for sharing their academic research experiences and giving their encouragements to me. My thanks also go to my PhD colleagues, Xiaodong Chen, Kailin Zou, Hongchao Zhang, Yan yang, Wenna Lu, Yongdeng Xu, Wei Yin and many others for their precious friendship. Lastly, I would like to thank my dearest family, my mum, Sufang Yuan, my dad, Youyuan Cao, my brother, Xiaojun Cao and my sister-in-law, Jia Xiang. They have been brilliant when I need them for support and comfort. My special thanks are given to my partner, Karl McKenzie for his love, care, support, and understanding. Without him, I could not have made it. I also would like to thank his family, his parents, Valerie Trigg and Carl Trigg. They are like another family in the UK for me and without them, my life in the UK wouldn’t have been so great. I am deeply indebted to all of people who have been there when I needed them for the last five years and no words can express how truly grateful I am. II TABLE OF CONTENTS ABSTRACT ............................................................................................................ I ACKNOWLEDGEMENT ...................................................................................... II TABLE OF CONTENTS…………………………………...…………………...III TABLE OF FIGURES ......................................................................................... VI LIST OF TABLES ............................................................................................. VIII 1. General Introduction ....................................................................................... 1 2. Literature Review .......................................................................................... 12 2.1 The Momentum Effect and Momentum Trading Strategies ....................... 12 2.2 Theoretical Explanations of the Momentum Effect and Momentum Profits .......................................................................................................................... 16 2.2.1 Rational Explanations of the Momentum Effect and Momentum Profits ....................................................................................................................... 16 2.2.2 Behavioural Explanations of the Momentum Effect and Momentum Profits ............................................................................................................ 18 2.3 Empirical Research on the Explanatory Power of Risk Factors and Behavioural Models .......................................................................................... 21 2.3.1 Empirical Research in Favour of Rational Explanations ..................... 21 2.3.2 Empirical Research in Favour of Behavioural Explanations ............... 24 2.4 Post-Cost Profitability of Momentum Trading Strategies .......................... 27 3. The Momentum Effect in the UK Stock Market 1979-2011 ........................ 31 3.1 Introduction ................................................................................................. 31 3.2 Motivation ................................................................................................... 33 3.3 Data and Momentum Portfolio Formation Method .................................... 35 3.3.1 Data ...................................................................................................... 35 3.3.2 Momentum Portfolio Formation Method ............................................. 35 3.4 Empirical Findings on the Profitability of Momentum Trading Strategies 38 3.4.1 Testable Hypotheses............................................................................. 38 3.4.2 Profitability of Momentum Trading Strategies and Significance of the Momentum Effect ......................................................................................... 39 3.4.2.1 Performances of Self-Financing Momentum Trading Strategies .. 40 3.4.2.2 Performances of Long and Short Positions of Momentum Trading Strategies ................................................................................................... 42 3.4.3 Dynamics of the Momentum Effect ..................................................... 49 3.4.3.1 Dynamic Performances of Individual Momentum Trading Strategies ................................................................................................... 49 3.4.3.2 Performances of Momentum Trading Strategies during Three Sub- Sample Periods .......................................................................................... 50 3.5 Tests of the Explanatory Power of Risk Factors......................................... 56 III 3.5.1 Tests of the Significance of CAPM-Adjusted and Fama-French-3- factor Risk-Adjusted Self-Financing Returns ............................................... 56 3.5.2 Tests of the Explanatory Power of the C-CAPM ................................. 58 3.5.3 Profitability of Momentum Trading Strategies
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