The Momentum Gap and Return Predictability
WFA 2015 Seattle Meetings Paper
53 Pages Posted: 17 Aug 2014 Last revised: 2 Mar 2019
Date Written: February 28, 2019
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 five 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 substantially increases its Sharpe ratio.
Keywords: Momentum, return predictability, market efficiency, behavioral finance, asset pricing anomaly
JEL Classification: G10, G12, G14
Suggested Citation: Suggested Citation