Price and earnings momentum: An explanation using return decomposition

Abstract

We test rational and behavioral explanations for price and earnings momentum applying a unified framework using return decomposition. The results demonstrate that momentum profits do not come from the expected return component. Instead, momentum profits are mainly contributed by the positive cash flow return component and partially offset by the negative discount rate return component. The cash flow return component is quite persistent before and after portfolio formation. However, the dynamics in the discount rate return component explain why the ex-ante expected return does not account for momentum returns. In comparison with price momentum, earnings momentum does not rely on past discount rate news and does not display long term reversal. Overall, our empirical evidence based on return decomposition tends to support the behavioral explanation that the market incorporates cash flow information too slowly, which drives momentum returns.JEL Classification: G11; G12; G14; M40

Earnings Momentum, Adaptation Value, and Nonlinearities in the Valuation of Chinese Equity Stocks

“…Moreover, the Ohlson (1995,(665)(666)(667)(668)(669)(670) model assumes that a firm's cash flows evolve in terms a first order system of stochastic difference equations stated exclusively in terms of the levels of the affected variables. However, recent empirical evidence shows that the momentum of variables comprising a firm's investment opportunity set can also have a significant impact on the expected present value of the firm's future cash flows (Chordia and Shivakumar 2006, Fama and French 2012, Chen et al 2014, Mao and Wei 2014. 1 Unfortunately, when an investment opportunity set is stated in terms of a first order system of stochastic difference equations as is the case with the Ohlson (1995) model, it cannot accommodate these momentum phenomena.…”

“…The empirical analysis summarized in the pages which follow shows, however, that momentum in the determining variables of firms listed on the Shanghai Stock Exchange does have a significant impact on their stock prices. Thus, our modelling procedures provide an analytical justification for the emerging empirical work that documents a significant association between earnings momentum and the market value of a firm's equity (Chordia and Shivakumar 2006, Fama and French 2012, Chen et al 2014, Mao and Wei 2014. 4 Bergstrom (1990, 1) notes that for the financial and other aggregates controlled by large publicly listed firms "there will be thousands of small changes at random intervals of time on a single day, and the changes occur at any time during that day.…”

“…Moreover, first order processes cannot accommodate certain factors which empiricists have shown to have a significant association with equity returns. Probably the most important of these is earnings momentum (Chordia and Shivakumar 2006, Fama and French 2012, Chen et al 2014, Mao and Wei 2014 which can only arise through an investment opportunity set defined in terms of a second (or higher) order system of differential (difference) equations. One can demonstrate the importance of this point by supposing the current increments in a firm's abnormal earnings and information variable hinge on the increments in these variables in previous periods.…”

Enhancing momentum investment strategy using leverage

“…On one hand, it is argued that momentum is due to underreaction to information (Daniel & Titman, 1999;Hong et al, 2000;Jegadeesh & Titman, 2001;Liu et al, 1999;Mao & Wei, 2014), and on the other hand, that it is risk related (Abinzano, Muga, & Santamaria, 2014;Agarwal & Taffler, 2008;Avramov et al, 2007;Booth, Fung, & Leung, 2016;Chordia & Shivakumar, 2002;Johnson, 2002;Wu, 2002). On one hand, it is argued that momentum is due to underreaction to information (Daniel & Titman, 1999;Hong et al, 2000;Jegadeesh & Titman, 2001;Liu et al, 1999;Mao & Wei, 2014), and on the other hand, that it is risk related (Abinzano, Muga, & Santamaria, 2014;Agarwal & Taffler, 2008;Avramov et al, 2007;Booth, Fung, & Leung, 2016;Chordia & Shivakumar, 2002;Johnson, 2002;Wu, 2002).…”

“…There is also extensive literature than analyses the origin of the momentum profits. On one hand, it is argued that momentum is due to underreaction to information (Daniel & Titman, 1999;Hong et al, 2000;Jegadeesh & Titman, 2001;Liu et al, 1999;Mao & Wei, 2014), and on the other hand, that it is risk related (Abinzano, Muga, & Santamaria, 2014;Agarwal & Taffler, 2008;Avramov et al, 2007;Booth, Fung, & Leung, 2016;Chordia & Shivakumar, 2002;Johnson, 2002;Wu, 2002).…”