Market State Impact on the Profitability of Cross-Sectional and Time-Series Momentum Strategy

What is it about?

In momentum trading strategy, investors focus on stocks that are moving significantly in one direction. For example, they buy (sell) stocks with higher (lower) returns in the past few months and hold them for the next few months. This trading strategy is found to be quite profitable. Investors chose stocks in momentum trading strategy mainly based on two ways, one is the cross-sectional performance of the stocks, and the other one is the time-series performance of the stocks. In cross-sectional (CS), they buy (sell) stocks that have outperformed (underperformed) the other stocks in the past few months. In time-series, they buy (sell) stocks that have excess positive (negative) returns over the risk-free rate in the past few months. In this paper (TS), we show that the TS strategy is more profitable than the CS strategy when the market continues the same state whereas it incurs more losses than the CS strategy when the market transitions. In simple words, the TS strategy generates higher momentum returns in the bull and bear markets whereas it incurs greater losses when the market transitions from the bull to bear or bear to bull state.

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Why is it important?

Until now, it was perceived that the TS strategy is more profitable than the CS strategy; however, our results show that the profitability of TS strategy over the CS strategy is conditioned to the overall market performance. Therefore, investors need to be careful while investing in momentum strategy when the markets are volatile.

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