The Reversal Effect in Stock Market
Highlights & Takeaway
- The 1-month price momentum captures the recent one month price change of the stock. It is often used in technical analysis and trend-following / mean-revert strategies, helping traders identify stocks or other assets that have shown extreme price movements in recent month, potentially indicating a reversal in direction in the upcoming month.
- Above reversal effect can be observed under SP 500: during past two decades, stocks that experienced the most significant gains during previous month tend to post worst returns over the next 30 days. On an annualized basis, last month “gainers” underperform “losers” by ~2% to 4%.
- The effect can also be found under the Russell 1000 universe. While for Russell 2000, the reversal effect disappears, where both last month “gainers” and “losers” deliver poor future returns. This may be attributed to the fact that Russell 2000 includes those small-cap and highly volatile companies, where volatility has a more significant influence on returns rather than price momentum. More details on the low volatility phenomenon can be found in our previous study notes:
Introduction & Intuition
In this section, we examine the above argument under our quantitative framework.
Factor Study Framework
We will analyze the performance of stocks with higher price momentum (1 month) compared to those with lower price momentum (1 month) during the period of January 2000 to March 2023, using the following framework to determine which group delivers better returns.
Price Momentum (1 Month) Factor in SP 500
The following results (Jan 2000 — Mar 2023) are displayed.
- Quintile Annualized Returns (both total return and alpha return).
- Quintile Long-Short Cumulative Returns, where the best quintile (Q1) is long and the worst quintile (Q5) is short.
1. Quintile Annualized Returns
Just as a reminder, we use two types of return measures in our analysis. Total return measures the overall return from the stock, which includes both the market return and the stock selection return. On the other hand, alpha return focuses solely on the stock selection return by removing the market return component from the stock return. This distinction will allow us to evaluate the effectiveness of the price momentum (1 month) factor more precisely.
Details on two return components can be found:
Quintile Analytics
Observations:
- Over the last two decades, within the S&P 500 universe, it has been observed that stocks exhibiting the strongest price momentum in the previous month tend to yield lower returns in the subsequent month. Meanwhile, stocks with relatively weak price momentum in the past month tend to deliver higher returns in the following month, confirming the reversal effect to some degree.
2. Quintile Long-Short Cumulative Returns
Long-Short (Q1 — Q5) Return Analytics (Monthly)
Observations:
- When compared to alpha (or so called risk-adjusted) return, the difference in total returns between stocks with favorable and unfavorable recent one-month price changes tends to be more significant. During the next one month, stocks experienced the most declines over the past month outperform those with most gains by 0.3%, and such effect is especially prominent during the last decade.
Price Momentum (1 Month) Factor in Russell 1000 and Russell 2000
It is worth noting that the S&P 500 index consists of the 500 largest and most actively traded companies in the US, where stocks are generally priced more efficiently than in other stock universes.
To determine whether our conclusions hold true in different stock universes, we extended our study to include the Russell 1000 and Russell 2000 universes. This expansion allowed us to compare the performance of stocks with higher price momentum (1 month) to those with lower price momentum (1 month) under different market conditions and environments.
- Quintile Annualized Returns
2. Quintile Long-Short Cumulative Returns
Observations:
- The reversal effect is also being observed under the Russell 1000 universe (similar to the SP 500), companies rallied the most during past month deliver worst returns in the following month.
- However, for Russell 2000, the pattern looks slightly different. Stocks with both best or worst past one-month price momentum tend to show poor returns in the coming month, whether measured on an absolute or alpha basis.
Notes:
- All data in the analysis are sourced from Yahoo Finance & Financial Modeling Prep.
- Past performance is no guarantee for future investment results.
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