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Analysis of Momentum in Indian Stock Markets

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Any opinions, findings, conclusions or recommendations expressed in this material are those of the authors and do not necessarily reflect the views of UK Essays.

Published: Thu, 01 Mar 2018


The first study on momentum based investment strategy was documented way back in 1967. Levi (1967) claims the success of trading strategy based on buying stock with current price significantly higher than the average of last 27 weeks generate significant positive abnormal returns. However Jensen & Bennington (1970) argues that the trading rule based on relative strength proposed by Levi was the one out of sixty eight trading strategies he tested and while tested for out of the sample test period it did not outperformed the buy & hold strategy and hence was attributable to selection bias.

Test of contrarian investment strategies was stealing the show fund managers were found busy picking stocks based on relative strength in US market. Majority of mutual funds examined by Grinblatt & Titman (1989) note the tendency of fund managers to buy the stocks that have seen price increase in last quarter. Apart from that Value Line rankings of mutual funds that were largely based on relative strength also enjoyed high predictive power. The success of mutual funds investing on the basis of relative strength and high predictive power of value line rankings (Copeland & Myres (1982)) provide some evidence of success of investment strategies based on relative strength.

The academic literature suggests contrarian returns generate abnormal returns whereas value line rankings and mutual funds generating abnormal returns based on relative strength strategy are in stark contrast of each other. A seminal study by Jegadeesh & Titman (1993) solves the puzzle by providing an explanation based on different of investment horizons considered by mutual funds using momentum strategies and contrarian strategies advocated by academic literature in late eighties and early nineties.

Jegadeesh and Titman (1993) using US market data from 1965-1989 found not only the evidence of long term success of contrarian investment strategy but also found that momentum strategies generate significant positive returns in medium run over 3-12-month holding periods. They documented the reversal of momentum after about nine months. Their study suggests that in short run for about 3-12 months holding period momentum strategy generate significantly positive returns while in long run for the holding period of 1-3 years contrarian strategy generates significantly positive returns.

Conrad and Kaul (1993) also find evidence from US market that the contrarian strategy is profitable for short-term (weekly, monthly) and long-term (2-5 years, or longer) intervals, while the momentum strategy is profitable for medium-term (3-12-month). As mentioned earlier the results of Jegadeesh and Titman (1993) had thrown a new light on seminal study of De Bondt & Thaler (1985, 1987) and found evidence of short term momentum precedes long term reversal. Although all the results provided strong evidence of market inefficiency, different studies documented different explanations for such returns. Fama & French (1996) presents result based on multifactor CAPM using size and MV/BV ratio to explain various anomalies in asset prices including momentum as well as contrarian returns and claim that market efficiency is intact. However the study failed to explain the presence of short term momentum using the multifactor model and hence short term momentum anomaly remains unexplained.

Several behavioural explanations were found and presented to jointly explain the short-run cross-sectional momentum in stock returns documented by Jegadeesh and Titman (1993) and the long-run cross-sectional reversal in stock returns documented by DeBondt and Thaler (1985). Daniel, Hirshleifer, and Subrahmanyam (1998) (DHS hereafter) assume that investors are overconfident about their private information and overreact to it. If these investors also have a self-attribution bias, then investors attribute success to their own skills more than they should and attribute failures to external noise more than they should. The consequence of this behaviour is that investors’ overconfidence increases following the arrival of confirming news. The increase in overconfidence furthers the initial overreaction and generates return momentum. The overreaction in prices will eventually be corrected in the long-run as investors observe future news and realize their errors. Hence, increased overconfidence results in short-run momentum and long-run reversal.

As against the above cited behavioral explanation to short term momentum and long term reversal, some scholars argue that the returns from these strategies are just compensation for taking additional risk or may be the product of the data mining. Most noteworthy of all – Conard and Kaul (1998) argue that the profitability of momentum strategies may be the result of data-mining and momentum portfolio shows positive returns in any post ranking period is true irrespective of the length of test period. Thus Conard and Kaul (1998) suggest that there is no case of long term reversal. This is diagonally opposite to what the behavioral models suggests where after short term momentum prices will reverse to more fundamental levels.

In fact, the criticism of Conard and Kaul (1998) led to another study by Jegadeesh and Titman (2001) where they used out of the sample test by using data from 1991 to 1998 – an overlapping test period compared to their 1993 study where they used data form 1965-89. Their study also eliminated small firms from the study to check whether the earlier momentum returns were actually dominated by small, high-risk and illiquid stock or otherwise. Though they focus on short term momentum in their study choosing two year holding period post formation but they also tested post holding period returns from the period of two to five years after formation.

They present some very interesting results. The momentum profits of Jegadeesh and Titman (1993) continued in 2001 also with almost same magnitude for same holding period that actually has proved that the earlier momentum profits were not the result of data-mining. It also suggests that unlike small firm effect where after the published research on superior returns on small firms compared to their large counterparts, superior returns on small firms disappeared in subsequent studies using data from the periods after the small firm effect from earlier studies got published, that means market has learnt quickly and hence such superior returns disappeared however momentum returns were still present with the same magnitude in 2001 as they were in 1993 study suggest that momentum returns are not just the temporary anomaly but it may have to do with some systemic cognitive bias which sustains for a long time. It also proves that momentum profit is just not the result of some small, illiquid and risky stocks and most noteworthy the reversal found in their post holding period cumulative returns, which render support to the explanations of behavioral theorists and provides evidence against the Conard and Kaul hypothesis.

As far as studies in Asian markets are concerned Chang (1995) found abnormal profits of contrarian strategies in the Japanese markets. Chui (2000) found significant positive abnormal returns with contrarian investment strategy in Japanese and Korean markets. Hameed & Ting (2000) found evidence of market overreaction hypothesis (contrarian strategy) in Malaysia. Kang (2002) found significant short term positive returns with contrarian strategy in Chinese markets.

On the other end, Hameed & Kusandi (2002) found no evidence of contrarian profits in six Pacific Basin markets. While Rouwenhorst (1998) and Griffin & Martin (2005) found existence of momentum in many non-US countries, the quantum of momentum returns in non-US countries was small, and in the case of Asia, insignificant. For example, Griffin (2005) estimates average monthly returns of 0.78%, 0.77% and 0.40% for the Americas (excluding the US), Europe and Asia respectively.

End of the Beginning or Beginning of the End…

The big bull has fallen down, investors have lost their vision, and experts’ knowledge went futile with the downturn of the global economies. When the markets were on peak, the funds across the world have flooded in the global economies. Policy makers had lot of confidence on the market, that it will help the economy to grow at faster pace. The market excelled 21000 points which was more ahead then the growth of the economy of India. But that does not seem true for the world economies, as the crisis had hit badly in USA and other parts of world which insisted FIIs and other investors to withdraw their money and markets crashed, went to 7000 points, where investor lost everything and policies could not work to take them up to the level. What was the reason of the crash? What will be the result of the market?

Is this the end of the beginning or beginning of the end?

Indian market is the strong base of determining the financial system of the country. Majority of the financial decisions are dependent on the stock market & other financial market. Indian stock market serves a link to banking and other financial policies which provides impetus to the industry. Indian stock markets heavily based on the sentiments of the clients (market players) & also of the market makers. The crash or boom (in a period/ year) determines the structure of the Indian capital system. The boom in the market (year till 2008) has brought many changes in the performance of mutual funds, insurance (ULIPS), & investment products which led the country into the inflow of the money supply in the market.

Till 2007-08 the market was running at its best, touched the heights, but the global crash in the market became a typhoon & took away major players & organizations into the quick sand of the recession. The insights from the market were not showing positive sign in anyways, so whether this was a new platform or just a time (economic) cycle.

Prologue to decline…

Earth provides enough to satisfy man’s need, but not greed. -M.K.Gandhi

The market crash started with the fall of big financial organizations in the USA& in the world like Lehman Brothers, AIG, Freddie and Fannie and many more. The failures were primarily due to exposure into

Subprime loans & Credit default swaps

issued to insure these loans & the issuers devolved resulted into bank failures & steep reduction in the price of equities worldwide.

The economic crisis led many world markets to suspend the trade due to fall in price.

On October 8, 2008 Indonesian stock market halted trading, after a 10 % drop in one day. The crash of 2008 was around 21% which was little less than 1987 (Times of London). Beginning of October month was Black in the world market. The Dow Jones volumes were low and the industrial average fell over 1874 points which was worst weekly decline.

The Icelandic stock market was into pitiable situation where the markets had been suspended for 3 days i.e. 9, 10 & 13 October. On October 24 many of the world’s stock market experienced the worst decline, with around 10% drop in the indices.



The above graph shows the steep and the worst decline a market could ever witness. The Iceland stock market crashed up to unpredictable level. The trading had been suspended for 3 days because of the crash in the market. This situation was visible in all global stock markets, because of financial crisis in USA.

Hence, the worst was yet to be experienced by the global markets & market players. The Indian stock markets were also badly hit & the confidence of people was shattered. The markets were not showing the positive sign in any of the context & people had no clue about the next jump or next level of the market. Market experts were expecting the markets will be into recuperation at the earliest, but things were not going the way it had been desired.

Source: Hindubusinessline.com

Indian market which has shown strong performance till 2007, but from January it plummeted more than 3000 points on all the stock prices & by October 2008, it had touched the 7000 (BSE) line. The continuous unpredictable scenarios in the stock market led many investors and institutional investors to withdraw their money because of negative performance of the markets.

The above shown graph is depicting the dream turned into nightmare for global & domestic investors.

The Beehive capitalism…

Everything that goes up without base falls steeply & with great force. The same situation has happened with the world economies. The supreme economy of the world has become the devil for the small economies, leading major & big companies to file for the bankruptcy.

The global meltdown is the result of Financial Hybrids & Innovations, which has been actively traded all across the world markets. The investment bankers, banks, financial institutions were actively relied on these new and innovative models, which has yet to gain the acceptance across the world. The main accused element for collapse is “Credit crisis”, in which the US banks got the regulations to lend money to the people having no sufficient background to get the loans. These kind of loans were termed as NINJA loans (NO INCOME, NO JOBS, NO ASSETS), & given in abundance by the US banks.

Emerging economies like India, China and other big economies were initially considered to be the places which will remain unaffected from the distortion of crisis. But despite of the strong fundamentals Indian economy dipped into the crisis. The stock market had lost more than 50% of its value (source: economic times), which shattered the hopes of the Indians. There was continuous monitoring by the Central Bank (Reserve Bank of India) on the market trend. The tornado of crisis had destroyed most of the stock markets, banks and financial institutions after soaring to the new heights of investment.

The below mentioned graph depicts the movement of BSE Sensex & S&P CNX Nifty

Source: SEBI Bulletin November 2008.

BSE Sensex closed at 9788 on October 31, 2008 as against 12680 on September 30, 2008, a fall of 3072 points (almost 24%).The month of October 2008 had been the most volatile month, where Sensex recorded a high of 13055.67 on October 1, 2008 & low of 8509.56 on October 27. Nifty closed 2886 on October 31 against 3921 against 30 September 2008. By the end of a month Nifty registered the fall of 1035 points (almost 27%). The market had shown unpredictability of the base & stability level, dissuading more and more investors to take exit from the market.

The Financial crisis:

A Sub-prime loan is a type of mortgage loan made to borrowers who have at least one of the following characteristics:

(1) Low credit scores;

(2) The inability to post the traditional 20 percent down-payment for a home; and/or

(3) The inability to fully document their income.

The subprime crisis is not the result of recent financial innovations and developments, but it is the outcome of lax capitalism policies which had been developed by the US government. In the fifties American government passed a legislation to delink the commercial banking & investment banking. The legislation stated implied that a commercial bank cannot open an investment bank.

In 70’s European & American economies faced slowdown, due to which these banks were finding difficult to invest their investible surplus. This time the East Asian economies were liberalizing their economies, due to which the capital from western economies started moving to these economies. After the huge influx of capital into these economies, Asian bubble gets burst, forcing the western economies to introduce new financial measures to invest into the markets. These circumstances and the need of new financial avenues led the US & European economies to trade into the new financial products, by liberalizing the norms for Commercial & Investment Banks.

The liberalization in the regulations led to the introduction of the Mortgaged products (a prime cause of crisis). In the late 90’s US mortgage lender began offering the mortgage products to would be “home buyers” who could not qualify for a mortgage loans. Millions of Americans & Europeans, who previously could not afford to buy home, were obtaining these mortgages, due to which great Demand of home (boom) took place leading to shoot of real estate prices.

The above diagram shows how the base of subprime crisis took place in the global markets. The downfall in the economies is considered to be as the Dominoes Effect. The lax screening of borrowers, large capital accumulation & capitalized market structure created a bubble which could not be ceased from getting expand. The whole cycle got mitigated with the introduction of new instruments in the financial markets. The sub prime crisis is about the collapse of the unregulated, $3 trillion over-the-counter market for complex structured assets, some of which happen to contain sub prime residential mortgages.

The semiannual global financial stability report by IMF said that declining US housing prices and rising delinquencies on the residential mortgage market could lead to losses of $565 billion. When combining these factors with other market factors, it puts potential losses at about $945 billion which is almost 25% of the $24trillion global credit market.

Financial innovations were brought into the market to make the products work in the market. The Mortgage products started to conflagrate the US & European markets, where such loans started becoming the pool of assets (Risky) and been traded in the market. Hence, due to this many other factors got the impetus ultimately resulted into the uncontrollable bubble of mortgage, which gets burst and deepened the world economies into the recession.

The subprime crisis has affected the global economies resulting into the fall of big financial corporation like Lehman Brothers, Bear sterns, AIG, Freddie & Fannie, and many more big organizations of whom one cannot think to get fail. The sizes of the organization (exposure) were in plethora that it was not possible for the US & European government to revive these financial institutions. AIG, one of the largest insurance companies (Private) became government undertaking due to the impacts of financial crisis.


Source: The India Economic Review 2008. (Dec 08)

The whole system works in three stages, Stage First consist of Borrowers & lenders; Second stage consists of the creation of

SpecialPurpose Vehicle (SPV)

with the inclusion of legal intermediaries. The last (third) stage consists of investors those who had invested their money into the riskier assets including the investment banks.

In stage first agent enters between borrowers and lenders, accepting the collateral and also factoring the future price rise. The agents accept the loans, who previously could not even qualify for the approval, now getting loans from the banks & other lenders. The housing price bubble allowed many borrowers to get loans easily because of the high house prices. The loans were mortgaged on a larger scale by creating the pool of similar group of mortgage assets through Special Purpose Vehicle (SPV) given the risk involved on the pool of assets.

In second stage, SPVs were created & all the liabilities were transferred into bankruptcy remote securitization trust or SPV. Underwriters were used to issue & market the MBS (mortgage backed securities). These securities were divided into different tranches, which were of similar securities. The rating agencies were to give rating to these tranches of securities. The ratings were given to the tranches based on the risk, priority of payment of the funds. Higher ratings were given to those tranches benefiting from the credit enhancements the MBS generates or credit insurance purchased from third party bond insurer.

In third stage, Institutional or individual investors such as hedge funds or managers of Collateralized Debt Obligations (CDOs), purchase the securities and then re-securitize the MBS, along with other assets, into a CDO. The Commercial Papers (CP) generated in the initial years was all sold and there was demand for more. Consequently the SPVs started producing more CPs or MBS. The sale of the same only meant that the SPVs were flush with funds. These funds were to be invested somewhere so, the agents were pressed to bring in more borrowers. The lending norms were further diluted to accommodate lesser and lesser deserving borrowers in order to deploy the huge funds available. The consequent spiral that got generated only led to the continued dilution of the Capital Adequacy and Prudence norms. The system went burst once the housing prices turned negative turning the very foundation of subprime lending upside down.

The turmoil of subprime has been expected of more than $ 3 trillion, which is too big for any country to even imagine of recuperating. The impact on Indian market was slow but had been proved acute on the stock market due to the constant humongous withdrawal of FIIs & loss of confidence in the consumers (investors).

Mortgage: Huge pack of cards…

The magnanimous crisis which all started with lax policies of US government, provided impetus for the Fed Reserve to implement new structures in the economy. The capitalist policy was looking very attractive to the market players, but the policy was hollow from the fundamentals. It all started with the Alan Greenspan’s reformative structures & models in the financial markets, led to turmoil in the global economies.

The US Fed Bank & Clinton government in 1999 passed

Gramm-Leach-Bliley Act

(GLBA) which had abjured the old

Glass-Steagall Act

which had regulated the Investment Banks, Banks & Insurance industries. The new legislation has unregulated the Wall Street Investment Banks and commercial banks. This deregulation has enlarged the gamut of activities in the financial activities of the commercial banks & other financial institutions. The deregulation had been further reintroduced by legalizing gambling activities into financial sector, a prohibition that had been in place after 1907 financial crisis. The steps towards deregulation of the US markets had converted the US markets into a big casino.

Securities Exchange Commission (SEC) in 2004 took a step towards the deregulation on the financial activities by removing the ceiling on risk that the largest American investment banks could take on Securitized loans. By this time, no one would have thought that the deregulation will result into large speculation & create a bubble in the market. Lastly, the

Securities and Exchange Commission took the last step toward deregulating financial markets when in the month of July 2007, weeks before the onset of the subprime crisis; it removed the “uptick” rule for short selling any security.

The housing bubble was fed by extraordinarily low interest rates & low lending standards (norms) for mortgages. The excessive monetary liquidity & short term interest rates fell to 1%, which led to high borrowing of loans from the banks, resulted into the big bubble of mismanagement of financial activities. After the tech bubble burst in 2001 & the recession, the Fed (Greenspan) aggressively lowered the Federal funds rate from 6.5 percent to 1 percent in 2004, the lowest since 1958. The lowered interest rates & reduced lending standards made the banks to lend the money known as ‘

Predatory Lending’

to the borrowers who did not have capabilities to qualify for the loans, but with the mortgage lending, excessive loans were provided to these lenders as they (banks) were getting big bonuses for bearing risk on these loans. Non-traditional home loans were advanced to borrowers who had no documented incomes.

Some loans were interest only loans with down payments of 5% or less

. Some were Adjustable Rate loans (ARMs), with low interest rates for one or two years to be reset later at much higher rates. In 2006 around 25% of American mortgages were subprime and close to 20% were ARMs. Mortgage lenders and Home buyers presumed that home prices were not going to fall on a national basis.


The subprime crisis is the result of new financial products in the market & the deregulation of the financial activities for the FIs. The main reason of such lending was the facility with which subprime lenders could sell their risky mortgages upstream to bigger players, investments banks for example, which undertook to buy them, pool them into mortgage bonds and re-channel them into new financial instruments through a process of aggressive securitization. The Structured Investment Vehicles (SIVs) which fall into the large class of derivative products came under various names such as

Collateral Debt Obligations

(CDOs). They had the characteristics of short term asset based commercial paper that were backed by the underlying income producing mortgage assets downstream and were graded according to a certain risk of default. More than 1 trillion & half dollars of these asset backed financial products were sold in all over the world.

Another new financial instrument that made matters much worse and led directly to the crisis: the Credit Default Swaps. Due to lack of government regulation, this product has become a weapon of mass destruction. In order to protect against the risk of default on the new asset-backed securities (ABS), some insurance companies but also some investment banks themselves began to issue bilateral “insurance” contracts against the newly created ABS. These were called Credit Default Swaps (CDS), which were supposed to protect the investment instruments against the default on asset based securities. The issuer of ABS could buy the protection against the default by paying a premium. This was a financial innovation, the so-called “insurance against default”, that opened the floodgates of money to be invested in the new financial instruments. Indeed, it allowed investors such as pension funds and other institutions which have a fiduciary obligation to buy only high-quality securities, to legally buy artificially highly rated (but risky) ABS securities, or to invest in hedge funds which specialized in leverage trading in derivative products. But the problem was that the issuance and use of such financial “insurance” contracts were not regulated by any government agency, because the word “insurance” was not used; instead, they were considered as simply a protection against the “default” of payment on a financial security. And that’s where the gambling part enters the picture: only ten percent of CDS are genuine insurance contracts held by investors who really own asset-backed securities (these are covered CDS); 90 percent of them are rather held by speculators who trade CDS, while not owning any asset-backed securities to be protected (these are naked CDS).

Economy as Casino:

The gamut of gambling that US government & Fed has created was even unimaginable, allowed big participation into these new investment instruments.

Credit Default Swaps (CDS) can be bought and sold by speculators who are not directly involved in the mortgage business. Because of the 2000 Commodity Futures Modernization Act passed by Congress, no state has the power to regulate this new form of sophisticated gambling. The result is astounding: it is estimated that the notional value of credit default swaps outstanding today is about $ 62 trillion (four times the size of the US economy). This is an indication of popularity of the “naked” CDS innovation was as a way to bet on the collapse of the entire asset-backed securities construction. This was also a clear sign that, in a crisis, it would be all but financially impossible for the issuers of CDS to meet their obligations. In other words, disaster was just around the corner. This is an event that any regulatory agency should have seen coming. When housing prices hit the expected top of their cycle, in the 2005, and began falling, especially in 2006, the price for CDSs was still relatively low. So, some astute speculators undertook to buy CDSs and simultaneously began selling short the ABS that had been issued by investment banks, such as Lehman Brothers, in the correct expectation that mortgage-backed securities were bound to lose value with the expected rise in home foreclosures and mortgage defaults. This is how unimaginable spiral got created by the steps undertaken by Fed Reserve & US government which ultimately result into the great burst ever faced in the history globally.


The Gramm Leach Billey Act 1999 (GLBA) passed by US government in the year 1999 with a view of security & data integrity in the market. The GLBA repealed the part Glass Steagall act of 1933, which had opened the market among the banking companies, securities companies & insurance companies. The GSA had prohibited any one institution from acting as any combination of an investment bank, a commercial bank and or an insurance company. But the GLBA allowed commercial banks, investment banks, securities firms, & insurance companies to consolidate.

The act was announced in the 1993 & finalized in 1994, allowing many big corporations to merge to enhance their range of activities & take the benefit of the deregulation. The law was passed to legalize these mergers on a permanent basis. The law has not fully deregulated the previous act, but they had relaxed the norms and allowed the FIs to have non financial assets. GLBA was amended with some part of the Bank Holding Company act of 1956. The crucial aspect of the GLBA stated that

no merger can go ahead until the financial holding institutions, or affiliates receives a “less than satisfactory (SIC) rating at its most recent CRA exam”.

GLBA compliance was mandatory; whether a financial institution discloses non public information or not, there must be a policy in place to protect the information from prospective threats in security & data integrity. The law was segregated into three main aspects:


This rule requires FIs to provide each consumer with a privacy notice at the time the consumer relationship is established and annually afterwards. The notice must explain the information collected about the consumer, where that information is shared, how that information is used and how that information about the consumer is protected. The consumer must be notified & give consent about any change at any point of time. Each time the privacy notice is reestablished the consumer has the right to opt it again.


The safeguards rule requires FIs to develop a written information security plan that describes how the company is prepared for, and plans to continue to protect clients’ non public personal information. This plan must include the following;

  • Denoting at least one employee to manage the safeguards.
  • Constructing a thorough on each department handling the non public information.
  • Develop, monitor & test a program to secure the information.
  • Change the safeguards as needed.

The Safeguards Rule forces financial institutions to take a closer look at how they manage private data and to do a risk analysis on their current processes.


The GLBA encourages the organizations covered by GLBA to implement safeguards against pre texting. Pre texting means when someone tries to access the personal nonpublic information without proper authority & approval. Thus the institutions having covered under the GLBA, needs to have control & safeguard the information of their client, to prevent the details from any misuse.



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