The Momentum Gap and Return Predictability
Review of Financial Studies, Forthcoming
57 Pages Posted: 17 Aug 2014 Last revised: 13 Sep 2021
Date Written: February 28, 2019
Abstract
The formation period return difference between past winners and losers, which I call the momentum gap, negatively predicts momentum profits. I document this for the U.S. stock market and find consistent results across 21 major international markets. A one-standard-deviation increase in the momentum gap predicts a 1.25% decrease in the monthly momentum return after controlling for existing predictors. This predictability extends up to 5 years for static momentum portfolios, consistent with time-varying investor biases. Following the simple real-time strategy of investing in momentum only when the momentum gap is below the 80th percentile delivers a Sharpe ratio of 0.78.
Keywords: Momentum, return predictability, market efficiency, behavioral finance, asset pricing anomaly
JEL Classification: G12, G14, G40
Suggested Citation: Suggested Citation