Momentum, Reversal, and the Firm Fundamental Cycle
54 Pages Posted: 12 Nov 2018 Last revised: 20 Nov 2018
Date Written: November 11, 2018
We link momentum and long-run return reversal to the cyclic behavior of firm fundamentals, which are represented by a fundamental index that summarizes succinctly and efficiently a broad range of business activities at firm level. In responding to repeated unanticipated positive (negative) shocks in fundamentals, investors continue to raise (lower) prices for winner (loser) firms, yielding momentum. However, due to the cyclicality of firm fundamentals, the unanticipated positive (negative) shocks decrease in magnitude overtime and eventually reverse, generating the reversal pattern. In addition, we find that firm fundamentals can explain stronger momentum in microcap stocks, and a long/short decile portfolio based on the firm fundament index outperforms the popular momentum portfolio substantially by doubling the Sharpe ratio and does not suffer crashes.
Keywords: Momentum, Reversal, Firm Fundamental Cycles, PLS, PCA
JEL Classification: G11, G14
Suggested Citation: Suggested Citation