Momentum Trading, Mean Reversal and Overreaction in Chinese Stock Market *

Transcription

1 Momentum Tradng, Mean Reversal and Overreacton n Chnese Stock Market * YANGRU WU Rutgers Unversty and Hong Kong Insttute for Monetary Research December 2003 (Prelmnary, Comments Welcome) ABSTRACT Whle the vast majorty of the lterature reports momentum proftablty to be overwhelmng n the U.S. market and wdespread n other countres, ths paper fnds that the pure momentum strategy n general does not yeld excess proftablty n the Chnese stock markets. We fnd nstead strong mean reverson. A pure contraran nvestment strategy produces postve excess returns and n general outperforms the pure momentum strategy. Momentum nteracts wth mean reverson. A strategy based on the rollng-regresson parameter estmates of the model combnng mean reverson and momentum generates postve excess returns n all cases, most of whch statstcally sgnfcant. The combned strategy outperforms both pure momentum and pure contraran strateges. The strategy loads postvely on the market rsk factor, but the beta rsk explans only a relatvely small part of the excess return. Nor s transactons cost a domnant factor n explanng the excess proftablty. Keywords: Chnese Stocks, Mean Reversal, Momentum, Overreacton * Address for correspondence: Rutgers Busness School-Newark & New Brunswck, Rutgers Unversty, Newark, NJ , yangruwu@andromeda.rutgers.edu, Phone: (973) , Fax: (973) Part of ths work was completed whle I vsted the Hong Kong Insttute for Monetary Research. I thank the Insttutes for ts hosptalty and fnancal support. The vews expressed n ths paper are those of mne and do not necessarly reflect those of the Hong Kong Insttute for Monetary Research, ts Councl of Advsors or Board of Drectors.

2 Introducton Fnancal economsts have documented a number of anomales n the stock market. Among these anomales, two of them have receved partcular attenton over the past decade, that s, longterm mean reversal and short-term momentum n equty returns. Jegadeesh and Ttman (1993) frst report that equty returns exhbt short-term contnuaton. They demonstrate that a momentum strategy of sortng frms by ther prevous returns over the past 6-9 months and holdng those wth the best pror performance and short sellng those wth the worst pror performance generates an excess return of about one percent per month for U.S. stocks. Ths fndng has motvated numerous researchers to study momentum n other markets and/or other sample perods, ncludng Jegadeesh and Ttman (2001), Rouwenhorst (1998), Chan, Hameed and Tong (2000), Grundy and Martn (2001), Grffn, J and Martn (2003), and Patro and Wu (2003), among many others. On the other hand, another strand of lterature documents that equty returns are negatvely serally correlated and stock prces have a tendency to revert to ther trend lnes over the long horzons. See Fama and French (1988), and Poterba and Summers (1988). DeBondt and Thaler (1985) show that a contraran nvestment strategy that buys the worst-performng stocks and short sells the best-performng stocks over the prevous 3-5 years can generate excess proftablty over the next 3-5 years. These results have stmulated other researchers to test for mean reverson and to nvestgate the proftablty of contraran-based strateges n other context. See, for example, Chopra, Lakonshok, and Rtter (1992), Rchards (1997), and Balvers, Wu and Gllland (2000). The purpose of ths paper s to study momentum and mean reversal n the Chnese stock markets. Ths research s nterestng for several reasons. Frst, whle numerous prevous researchers document the proftablty of momentum-based tradng strateges, most of them focus on developed 1

3 (matured) markets. 1 The Chnese stock markets were frst establshed n the early 1990 s and have snce been rapdly growng n terms of the number of traded companes, tradng volume and market captalzaton. Over the past decade, the performance of the Chnese stocks may be characterzed as hgh returns and excessve volatlty, as compared to stocks traded n more matured markets, such as the Unted States. It s of partcular nterest to nvestgate whether these two anomales, momentum and mean reversal, whch are frst documented for the U.S., also exst n ths young emergng market. Second, most prevous researchers study momentum and mean reverson separately. In a recent paper, Balvers and Wu (2003) demonstrate that mean reverson and momentum can smultaneously occur to the same set of assets and that t s mportant to consder the nteracton between the two. Usng data for equty market ndexes for 18 developed countres, they show that mean reverson and momentum are n fact negatvely correlated. Furthermore, controllng for mean reverson extends the duraton of momentum and combnng mean reverson ncreases the speed of reverson. Followng Balvers and Wu (2003), ths paper adapts a smple tme-seres model to capture both the short-term and long-term dynamcs of Chnese stock prces n a unfed framework. Pure mean reverson and pure momentum can be treated as specal cases that are ncely nested n the general specfcaton. We use the model to study the relatve mportance of momentum and mean reverson and the proftablty of the assocated nvestment strateges n Chnese stock markets. To summarze the result at the outset, usng daly data for all A share stocks traded at the Shangha Stock Exchange (SHSE) from ts ncepton (December 12, 1990) to December 31, 2001, we fnd the pure momentum strategy of Jegadeesh and Ttman (1993) n general does not produce sgnfcant excess returns for the arbtrage portfolo of buyng the top decle portfolo and short 1 Exceptons are Grffn, J and Martn (2003), and Chan Hameed and Tong (2000), who nclude some emergng markets n ther samples. 2

4 sellng the bottom decle portfolo, for the cases of sortng the stocks based on pror 3-12 months returns and holdng the stocks for 3-12 months. On the other hand, we fnd mean reverson to be more mportant. A pure contraran strategy yelds postve excess returns for the arbtrage portfolo for all relevant holdng perods, and t beats the pure momentum strategy for 40 out of 42 cases consdered. The excess returns are statstcally sgnfcant at the 5% level for holdng perods of 6-12 months. Addng momentum to mean reverson greatly mproves the performance of the arbtrage portfolo. In partcular, the combned strategy outperforms the pure momentum strategy for all relevant cases (3-12 months rankng and 3-12 months holdng perods) orgnally studed by Jegadeesh and Ttman (1993). Our baselne case (12-month rankng and 12-month holdng) produces an annualzed excess return of 22.2%, whch s statstcally sgnfcant at the 5% level. The arbtrage portfolo has a postve loadng on the market rsk factor, but the beta rsk n general explans less than half of the excess returns. The fndngs for the A share stocks traded at the Shenzhen Stock Exchange (SZSE) are even stronger. The paper proceeds as follows. Secton I spells out the model and dscusses estmaton ssues. Secton II descrbes the data and presents some summary statstcs of the data. Results on pure momentum strateges are dsplayed n Secton III. Secton IV reports the results from the pure contraran strategy and the combned strategy of momentum wth mean reverson. Secton V conducts a number of robustness checks and the fnal secton concludes the paper. I. A Parametrc Model Combnng Momentum wth Mean Reverson Followng Fama and French (1988) and Summers (1986), we decompose the prce of a stock nto two components: one permanent and one transtory. The permanent component can be nterpreted as the fundamental value of the stock whle the transtory component can be vewed as a temporary devaton of actual stock prce from ts market fundamentals. Ths temporary devaton 3

5 from fundamentals s frm specfc and can be nterpreted as noses or fads. Because n the long run, the prce of an asset s ultmately determned by ts fundamentals, a devaton from fundamentals should be self-correctng,.e. t should be mean revertng. However, over the short horzons, temporary devatons can have postve feedbacks so that returns may exhbt momentum. Specfcally, let p t denote the logarthm of stock prce wth dvdends renvested for company, so that ts frst dfference p = p - p represents the contnuously compounded t t t-1 return. We decompose p t as follows: p t = y t + x t (1) where y t represents the permanent component and x t represents the temporary component. It s apparent that nether x t nor y t s drectly observed. By mposng some restrctons, t s possble to put the above model n a state-space format and to estmate the two unobservable components through the Kalman flter. However, ths wll sgnfcantly ncrease the computatonal burden. We nstead use the value-weghted market ndex as a proxy for the permanent component. Wth ths assumpton, the temporary component s smply the dfference between the log of stock s prce and the log of the value-weghted market ndex prce and the model can be easly estmated usng smple lnear regressons. The temporary component x t s assumed to possess short-term momentum and long-term mean reverson as follows: x t = J ( 1 δ ) µ + δ x + φ xt - j + η. (2) t - 1 j=1 j t In equaton (2), f δ < 1, xt has mean reverson. It converges to ts uncondtonal mean µ wth the speed of (1 δ ). The J lagged terms xt j are to capture the short-term feedback effects and f φ > 0 represent return momentum. The error term η j t s assumed to be a whte nose and to be uncorrelated wth the regressors. Snce we use the market ndex to proxy the fundamental/permanent 4

6 component, t s easy to see that the pure mean reverson model and the pure momentum model can be ncely nested nto ths general model. For example, settng φ = 0, equaton (2) becomes the pure mean reverson model, consdered by Balvers, Wu and Glllland (2000). On the other hand, by constranng δ = 1 and φ = 1 for all j, we obtan the pure momentum case of Jegadeesh and Ttman (1993). j j II. Data and Summary Statstcs All stock and market ndex prces are obtaned from the Chna Stock Markets and Accountng Research Database, publshed by Guotaan Informaton Technology, Ltd. We collect daly ndvdual stock prces (wth dvdends renvested) for all 637 A share stocks traded at the SHSE. 2 The sample started on December 12, 1990 and ended on December 31, 2001, wth 2732 daly return observatons. Daly returns on the value-weghted and equally-weghted market portfolos for the SHSE are also obtaned from the same source. The data for SZSE started on July 3, 1991 and ended on December 31, 2001 wth 2615 returns observatons for 503 A share stocks. The value-weghted and equally-weghted market ndexes for the SZSE are also collected. We proxy the rsk-free rate by the short-term bank nterest rate obtaned from IMF s Internatonal Fnancal Statstcs (lne 92460ZF). The nterest rate data s monthly at source and s nterpolated nto the daly frequency. Table I presents some summary statstcs of daly stock returns of the two data sets. They nclude cross-sectonal dstrbutons for the mean return, standard devaton, Sharpe rato, sample sze, market captalzaton and market beta for the ndvdual stocks traded n both markets. The 2 There are two types of shares traded at the Chnese stock markets: A shares and B shares. A shares are quoted n the domestc currency unt (RMB) and are traded only by domestc Chnese ctzens, whle B shares are quoted n U.S. dollar terms and can be traded only by foregners. 5

7 correspondng statstcs for the value-weghted and equally-weghted market ndexes are also reported. There are n general large cross-sectonal varatons n these statstcs. Among the 637 stocks traded at the SHSE, the mean daly return rate ranges from -0.91% to 0.34%, wth the medan of 0.08%. Over the full sample perod, the mean daly return for the value-weghted average of the Shangha market s 0.15%, and for equally-weghted average s 0.23%. The cross-sectonal dsperson for the standard devaton for these stocks s even bgger, rangng from 1.45% to 10.46% wth a medan of 2.67%, whle the value-weghted and equally-weghted market ndexes have standard devatons of 3.43% and 3.90%, respectvely. Over the same sample perod, the mean daly return on the value-weghted New York Stock Exchange (NYSE) ndex s 0.056%, and ts daly standard devaton s 0.85%, whle the correspondng numbers for the equally-weghted NYSE Index are 0.064% and 0.62% (not reported n the table). These numbers ndcate that the daly mean returns of the SHSE market ndexes are about 3 tmes as large as the NYSE, but the standard devatons are around 4-6 tmes as large as the NYSE. Results reported n the lower panel of Table I for stocks traded at the SZSE tell a smlar story. Overall, Chnese stocks over the last decade can be characterzed as hgh return and excessve volatlty. III. Proftablty of Pure Momentum Strateges In ths secton, we report evdence on the proftablty of pure momentum tradng strateges. As demonstrated n Secton II, the pure momentum model can be treated as a specal case of our flexble parametrc model (2) by settng δ = 1 and φ = 1 for all j. We consder varous combnatons of rankng perods (J) and holdng perods (K). In addton to those combnatons (J, K=3, 6, 9, 12 months) orgnally nvestgated by Jegadeesh and Ttman (1993), we add the cases of 1-week rankng perod and 1-day and 1-week holdng perods. Our experment follows Jegadeesh j 6

8 and Ttman (1993). At the begnnng of each perod t, all stocks are ranked n ascendng order on the bass of ther returns n the past J perods. We then form ten decle portfolos, each of whch s an equal weghted average of all stocks contaned n that decle. The top portfolo s denoted by Max and the bottom portfolo s denoted by Mn. We follow Jegadeesh and Ttman (1993) to examne portfolos wth overlappng holdng perods. In order to make the results from pure momentum strateges comparable to those from the combned momentum and mean reverson strateges to be presented n the next secton, we start formng our momentum portfolo at 1/3 of the sample (on July 15, 1994). The frst 1/3 of the sample s needed to obtan reasonably accurate estmates of the model parameters for our combned strateges. Table II reports the results on the performance of pure momentum tradng strateges for all A share stocks traded at the SHSE. We report the mean return of the top decle portfolo ( Max ), the excess return of the top decle portfolo over the bottom decle portfolo ( Max-Mn ), the excess return of Max over the value-weghted market portfolo ( Max-vw mkt ), and the excess return of Max over the equally-weghted market portfolo ( Max-ew mkt ). All return measures are annualzed. The correspondng t-rato for each tradng strategy s also presented. For the Max-Mn strateges, t-ratos n bold face and talczed denote statstcal sgnfcance at the 10% level or better usng a two-sded test. Overall, these results are rather mxed concernng whether momentum proftablty exsts. There are altogether 42 dfferent combnatons of (J,K), among whch 15 cases have negatve excess returns on the momentum strategy ( Max-Mn ). Furthermore, usng a two-sded test, we fnd that three of these 15 cases are sgnfcantly negatve at the 5% level (J=1 week, K=1 day; J=1 week, K=1 week; and J=3 months, K=1 day), and two of them are sgnfcantly negatve at the 10% level (J=9 months, K=1 day; and J=12 months, K=1 day). Of those cases whch have postve excess returns, 7

9 only two are sgnfcant at the 5% level (J=1 week, K=12 months; and J=3 months, K= 12 months), and three are sgnfcant at the 10% level (J=1 week, K=9 months; J=3 month, K=9 months; and J=1 months, K=12 months). Interestngly, for the cases that Jegadeesh and Ttman (1993) and others fnd momentum to be the strongest (namely J, k=6 months; and J, K=9 months), we do not fnd the excess returns to be sgnfcant, albet the pont estmates of returns are both postve. Whle the momentum portfolo n general does not produce sgnfcant excess returns n the vast majorty of cases, the top decle portfolo does yeld a hgher return than the value-weghted market portfolo n many cases when the rankng perod s shorter than 6 months, and the top decle portfolo sgnfcantly beats the value-weghted market portfolo at the 10% or better n 5 out of 7 cases when J=1 week. These results suggest that the momentum strategy seems to pck the wnnng stocks more accurately than to pck the losng stocks. The evdence aganst a pure momentum strategy from stocks traded at the SZSE s stronger, as can been seen from Table III. Frst, of the 42 cases nvestgated, 30 have negatve excess returns for the momentum portfolo. Sx of these excess returns are sgnfcantly negatve at the 5% level (J=1 week, K=1 week; J=3 months, K=1 day; J=3 months, K=1 week; J=9 months, K=1 day; J=9 months, K=1 week; and J=12 months, K=1 day), and two of them sgnfcant at the 10% level (J=3 months, K=1 months; and J=6 months, K=1 day). For the 12 cases that produce postve excess returns, none of them are sgnfcant at the 10% level. Furthermore, we fnd the excess returns to be negatve for the two cases (J, K = 6 months and J, K = 9 months) where prevous researchers fnd momentum to be the strongest n other markets. Smlar to the Shangha market, the wnnng decle portfolo yelds a hgher return than the value-weghted market portfolo n a number of cases when the rankng perods are relatvely short. In summary, whle the extensve lterature reports that momentum s pervasve and 8

10 wdespread across equty markets and tme perods, the results reported n ths secton do not by themselves make a strong case for the proftablty of pure momentum nvestment strateges n the Chnese equty markets. These results are consstent wth Grffn, J and Martn (2003) who use a smaller sample of Chnese stocks (253 stocks from July 1994 to December 2000) and report that the excess return for the momentum strategy of (J, K = 6 months) s close to zero. IV. The Proftablty of the Combned Strateges If equty prces also dsplay long-term mean reverson, then the mean reversal effect can nterfere wth short-term momentum. In ths case, estmaton of momentum wthout controllng for mean reverson wll be dstorted, renderng the pure momentum strategy unproftable, even f momentum does ndeed exst. We suspect ths may be the case for Chnese stocks. Whle t s possble to examne the long-term mean reverson effect wthn the nonparametrc framework of DeBondt and Thaler (1985, 1987), who use a 3-5 years rankng perod and 3-5 years holdng perod to nvestgate the proftablty of a contraran strategy for U.S. equtes, Balvers, Wu and Grllland (2000) demonstrate that a parsmonous parametrc model can be used to better characterze longterm mean reverson and that a tradng strategy based on forecast obtaned from a rollng regresson yelds better portfolo returns than the nonparametrc approach. It s ths parametrc rollngregresson approach that we adapt here to examne the proftablty of contraran and combned strateges. Startng at 1/3 of the sample, we use rollng regresson parameter estmates of equaton (2) to forecast the expected return for the upcomng perod for each stock. We then rank all stocks n ascendng order accordng to ther expected returns for the upcomng perod. We buy 10% of the stocks wth the hghest expected returns and short sell 10% of the stocks wth the lowest expected 9

11 returns, based on equaton (2) and usng parameters estmated from pror data only. We frst examne the case of pure mean reverson. Ths s done by settng all momentum parameters φ = 0 n equaton (2), leavng µ and δ the only parameters to estmate. The top panel j of Table IV reports the performance of the pure contraran strategy for SHSE stocks, from whch several observatons can be made. Frst, the pure mean reverson strategy produces a postve excess return for all holdng perods. Furthermore, the excess returns are statstcally sgnfcant at the 5% level for K=6, 9, and 12 months, and at the 10% level for K=3 months. Second, these return measures are economcally mportant rangng from 3.1% to 22.8% per year, wth the average of 11.6% per year. Thrd, the top decle portfolo Max beats the value-weghted market portfolo at the 5% sgnfcance level for all holdng horzons. The return of the top decle portfolo s also hgher than the equally-weghted market return for all holdng perods except K=1 month. Fourth, compared to the results of the pure momentum strategy n Table II, for each holdng perod K, the pure mean reverson strategy n general produces hgher excess profts than the correspondng pure momentum strategy regardless of the number of momentum lags used. The only exceptons are the cases of J=1 week and 1 month, and K=1 month, where the pure momentum strategy yelds slghtly hgher returns than the pure mean reverson strategy. The top panel of Table V dsplays the performance of pure mean reverson strategy for the SZSE stocks. Whle the excess return of the contraran strategy s statstcally sgnfcant at the 10% level n only one case (K=3 months), these excess return numbers are n general economcally large wth the average annual excess return of 8.69% across the 7 holdng perods. Furthermore, the top decle portfolo beats the value-weghted market portfolo at the 5% sgnfcance level, and the equally-weghted average market ndex (albet not statstcally sgnfcant) for all holdng perods. More mpressvely, at each holdng horzon, the pure mean reverson strategy outperforms all pure 10

12 momentum strateges. The above results suggest that mean reverson exsts and may ndeed be stronger than momentum n Chnese stocks. We next nvestgate whether accountng for mean reverson and momentum smultaneously can further mprove the performance of the tradng strategy. To ths end, we estmate model (2) wth momentum terms added. To ncrease estmaton effcency, we constran the momentum parameters to be the same,.e. we set φ = φ for all lags j. Smlar to the prevous experment, we start the forecast perod at 1/3 of the sample on July 15, 1994 and update parameter estmates as we roll the sample forward. Panels 2 to 7 of Table IV show the results from the combned mean reverson wth momentum strategy for the SHSE stocks. The momentum lags selected are the same as those n the pure momentum cases dscussed n Secton III above. Several comments are noteworthy. Frst, the excess returns of the tradng strategy ( Max-Mn ) are postve n all 42 cases, regardless of the number of momentum lags selected and the length of holdng perods used. Furthermore, 13 cases are statstcally sgnfcant at the 5% level or better and 10 addtonal cases are sgnfcant at the 10% level (all n bold face and talczed). Second, these fgures are n sharp contrast wth those from pure momentum tradng strateges reported n Table II. A comparson case by case reveals that the excess proftablty from our combned strategy wth mean reverson s hgher than the pure momentum strategy n all but three cases (J=1 week, K=1 months; and J=1 month, K=1 week; and J=1 month, K=1 month). These results ndcate the mportant role played by the mean reverson factor. Thrd, the top decle portfolo generates hgher returns than the value-weghted market ndex n all 42 cases, and than the equally-weghted average ndex n 26 out of 42 cases. Furthermore, n 35 out of 42 cases, the top decle portfolo beats the value-weghted market portfolo at the 5% sgnfcance level. Fourth, compared wth the pure mean reverson case, we fnd that the excess returns of the combned j 11

13 strategy are hgher n numerous cases especally when the momentum lag s long. For each holdng perod (K), we average the excess returns of the combned strategy across sx dfferent momentum lags. Ths yelds the average returns of 11.61%, 5.36%, 6.57%, 9.76%, 14.50%, 18.86% and 21.76%, for K=1 week up to 12 months, respectvely, for the combned strategy. Fve out of seven are hgher than the correspondng fgures from the pure mean reverson strategy. Ths smple comparson justfes the benefts of addng momentum nto the mean reverson model. Panels 2 to 7 of Table V report the results of portfolo performance for the combned tradng strategy for the SZSE stocks. Overall, these results are stronger than those from the SHSE stocks. Frst, the combned strategy yelds postve excess returns ( Max-Mn ) for all rankng and holdng perods. Of the 42 cases examned, the excess return s statstcally sgnfcant at the 5% level for 19 cases, and at the10% level for an addtonal 9 cases. Second, compared to the pure momentum case n Table III, the strategy combnng momentum wth mean reverson produces hgher excess returns for all rankng and holdng perods. Thrd, to make a comparson wth the pure mean reverson strategy, for each holdng perod (K) we compute the average excess return of the combned strategy over all rankng perods (J). Ths yelds the average excess return fgures of 20.85%, 14.87%, 13.68%, 15.43%, 13.00%, 14.07%, and 14.55% for the holdng perods K=1 day up to 12 months, respectvely. Qute strkngly, each of these numbers s hgher by a substantal margn than the correspondng one for the pure mean reverson case. Fourth, most mpressvely, the top decle portfolo generates a hgher return than both the value-weghted and equally-weghted market portfolos regardless of rankng and holdng perods. Furthermore, the top decle portfolo beats the value-weghted market ndex at the 5% sgnfcance level n all 42 cases. In sum, the evdence presented n ths secton suggests that Chnese stocks exhbts strong mean reverson, and mean reverson can ndeed be more mportant than momentum. The exstence 12

14 of mean reverson may nterfere wth short-term momentum and t s necessary to control for mean reverson when estmatng the duraton and mpact of momentum. A strategy combnng momentum and mean reverson n a unfed framework produces hgher returns than the pure mean reverson strategy whch n turn outperforms the pure momentum strategy. V. Robustness of Results The prevous secton documents the success of the smple two-component tme seres model of stock prces, whch combnes short-term momentum and long-term mean reverson n equty returns. In ths secton, we conduct a number of robustness checks for the model. We take as the baselne case of the combnaton strategy wth mean reverson and 12-month momentum and 12- month holdng perod, and do a number of experments on ths baselne model. Frst, Jegadeesh (1990) and Lehmann (1990) report that for very short rankng and holdng perod, reverson rather than momentum s observed n U.S. equty market. These authors argue that ths phenomenon could be caused by bd-ask bounce and/or nfrequent tradng. Other authors (e.g. Berk, Green and Nak (1999)) suggest extreme returns sgnalng changes n systematc rsks as a possble explanaton. Accordngly, researchers suggest skppng one perod between the portfolo rankng and holdng perods. In our case, we form the strategy portfolo one day after the stocks are ranked. Second, the results reported so far are all based on sortng stocks nto 10 decle portfolos. Whle ths s common practce for studes usng U.S. data, we acknowledge that the total number of stocks n the Chnese markets s far smaller than n the U.S. markets, and each decle may contan too few stocks especally n the early part of the sample. We therefore consder sortng stocks nto 3 and 5 equal-szed portfolos and study the excess return of buyng the top portfolo and shortng 13

15 the bottom portfolo. We also sort the stocks nto 20 equal-szed portfolos and document the excess return of the top-bottom portfolo to see whether certan outlers n the extreme portfolos can sgnfcantly affect our results. Thrd, we check how systematc market rsk and transactons costs affect our strategy returns. Table VI reports these results for the SHSE stocks where the baselne case s replcated here for easy of comparson. Our baselne case produces a 22.2% annualzed excess return whch s sgnfcant at the 5% level. Ths portfolo does load postvely on the market rsk factor (wth beta = 0.497). Correctng the rsk premum due to the postve factor loadng, we fnd the rsk-adjusted excess return (the alpha) to be 11.2%. Therefore, market rsk accounts for nearly 50% of the excess return. Ths s n stark contrast wth prevous studes usng data from other markets, such as Jegadeesh and Ttman (1993), Grundy and Martn (2001), Chorda and Shvakumar (2002), Chan, Jegadeesh and Lakonshok (1996), Balvers, Wu and Grllland (2000), and Rouwenhorst (1998). These authors report that the smple market beta rsk explans vrtually nothng of the excess return, and n many cases the excess return has a negatve market factor loadng. Our top decle portfolo produces a hgher Sharpe rato than the value-weghted market portfolo but a lower Sharpe rato than the equally-weghted market ndex. Our strategy nvolves an average portfolo turnover rate of 88% per year, a relatvely low number. Apparently, a reasonable transactons cost per trade, say 1-2%, wll only reduce a small porton of the total excess return. Therefore, transactons cost tself does not provde an obvous explanaton of the excess proftablty. Skppng one day between the rankng and holdng perods slghtly reduces the excess return to 20.8%, whch s statstcally sgnfcant at the 10% level. The rsk-adjusted return also decreases by the same amount (to 9.8% per year). Therefore, the bd-ask bounce or other mcro-structure bases are unlkely to be the mportant factors affectng our results. 14

16 Sortng stocks nto 3 portfolos does sgnfcantly reduce the excess return. The 11.8% annualzed return s now statstcally nsgnfcant. Furthermore, the rsk-adjusted return becomes a much smaller 4.9%. However, sortng stocks nto 5 portfolos produces an excess return of 17.4%, whch s sgnfcant at the 10% level, and a rsk-adjusted return of 9.0%, smlar to the baselne case. Fnally, a much fner sort of stocks nto 20 portfolos dramatcally ncreases the excess return to 35.2%, whch s sgnfcant at the 1% level, wth a large rsk-adjusted return of 20.0%. These results accord well wth ntuton and demonstrate that our smple two-component model combnng momentum and mean reverson characterzes the dynamcs of Chnese stock returns reasonably well. Table VII reports the results for robustness checks for the SZSE stocks. These results are qualtatvely smlar to those for the SHSE stocks and n general stronger quanttatvely. In partcular, we fnd that the beta rsk n general explans a smaller proporton of excess returns than for the SHSE stocks. VI. Summary and Conclusons The purpose of ths paper has been to nvestgate whether momentum and/or mean reverson exsts n the Chnese stock markets. Whle the vast majorty of the lterature reports momentum proftablty to be overwhelmng n U.S. equty market, and wdespread n other countres, we fnd that the pure momentum strategy produces qute weak and n some cases even negatve excess proftablty n the Chnese stock markets. Ths s especally the case for the ntermedate-term sortng and holdng perods (6-9 months), whch many researchers fnd momentum to be the strongest. On the other hand, we fnd strong mean reverson n the Chnese stock markets. A pure parametrc contraran nvestment strategy produces postve excess returns for all holdng perods 15

17 and the pure contraran strategy n general outperforms the pure momentum strategy. The exstence of mean reverson does not by tself preclude short-term momentum. Instead, we fnd momentum nteracts wth mean reverson. A two-component model for stock prce provdes a parsmonous characterzaton of these two effects and ther nteractons. A strategy based on the rollng-regresson parameter estmates from the model generates postve excess returns n all cases, most of whch statstcally sgnfcant. Ths combned strategy n general outperforms both the pure momentum strategy and the pure mean reverson strategy. The strategy loads postvely on the market rsk factor, but the beta rsk explans only a relatvely small part of the excess return. Nor s transactons cost a domnant factor explanng the excess proftablty. Future research needs to nvestgate the sources of excess proftablty and to seek plausble explanatons for the abnormal returns. In partcular, can the excess returns be explaned by a ratonal asset prcng model, or are they prmarly caused by some knds of behavoral bases, as advocated by Danel, Hrshlefer, and Subrahmanyam (1998), Barbers, Shlefer, and Vshny (1998), and Hong and Sten (1999). We are currently workng towards that drecton. 16

18 References Balvers, Ronald J., Yangru Wu, and Erk Gllland, 2000, Mean reverson across natonal stock markets and parametrc contraran nvestment strateges, Journal of Fnance 55, Balvers, Ronald J., Yangru Wu, 2003, Momentum and Mean reverson across natonal equty markets, mmeo, Rutgers Unversty. Barbers, Ncholas, Andre Shlefer, and Robert Vshny, 1998, A model of nvestor sentment, Journal of Fnancal Economcs 49, Berk, Jonathan B., Rchard C. Green, and Vasant Nak, 1999, Optmal nvestment, growth optons, and securty returns, Journal of Fnance 54, Chan, Lous K. C., Narasmhan Jegadeesh, and Josef Lakonshok, 1996, Momentum strateges, Journal of Fnance 51, Chan, Kalok, Allaudeen Hameed, and Wlson Tong, 2000, Proftablty of momentum strateges n the nternatonal equty markets, Journal of Fnancal and Quanttatve Analyss 35, Chna Stock Markets and Accountng Research Database, 2002, Guotaan Informaton Technology Co., Ltd, Shenzhen, Chna. Chorda, Tarun, and Lakshmanan Shvakumar, 2002, Momentum, busness cycle, and tme-varyng expected returns, Forthcomng Journal of Fnance. Chopra, Navn, Josef Lakonshok, and Jay R. Rtter, 1992, Measurng abnormal performance: Do stocks overreact?, Journal of Fnancal Economcs 31, Conrad, Jenfer, and Gautam Kaul, 1998, An anatomy of tradng strateges, Revew of Fnancal Studes 11, DeBondt, Werner, and Rchard Thaler, 1985, Does the stock market overreact?, Journal of Fnance 40, DeBondt, Werner, and Rchard Thaler, 1987, Further evdence of overreacton and stock market seasonalty, Journal of Fnance 42, DeLong, J. Bradford, Andre Shlefer, Lawrence H. Summers, and Robert J. Waldmann, 1990, Postve feedback nvestment strateges and destablzng ratonal speculaton, Journal of Fnance 45, Fama, Eugene, and Kenneth French, 1988, Permanent and temporary components of stock prces, Journal of Poltcal Economy 96, French, Kenneth, and James M. Poterba, 1991, Investor dversfcaton and nternatonal equty markets, Amercan Economc Revew 81, Grffn, John M., Susan J, and Spencer Martn, 2003, Momentum nvestng and busness cycle rsk: evdence from pole to pole, Journal of Fnance, forthcomng. Grundy, Bruce and J. Spencer Martn, 2001, Understandng the nature and the rsks and the sources 17

19 of the rewards to momentum nvestng, Revew of Fnancal Studes 14, Hong, Harrson, and Jeremy C. Sten, 1999, A unfed theory of underreacton, momentum tradng, and overreacton n asset markets, Journal of Fnance 54, Jegadeesh, Narasmhan, 1990, Evdence of predctable behavor of securty returns, Journal of Fnance 45, Jegadeesh, Narasmhan, and Sherdan Ttman, 1993, Returns to buyng wnners and sellng losers: Implcatons for stock market effcency, Journal of Fnance 48, Jegadeesh, Narasmhan, and Sherdan Ttman, 2001, Proftablty of momentum strateges: an evaluaton of alternatve explanatons, Journal of Fnance 56, Lehmann, Bruce, 1990, Fads, martngales and market effcency, Quarterly Journal of Economcs 105, Lo, Andrew W., and A. Crag MacKnlay, 1988, Stock market prces do not follow random walks: Evdence from a smple specfcaton test, Revew of Fnancal Studes 1, Lo, Andrew W., and A. Crag MacKnlay, 1990, When are contraran profts due to stock market overreacton? Revew of Fnancal Studes 3, Patro, Dlp K. and Yangru Wu, 2003, Predctablty of short-horzon equty returns n nternatonal equty markets, Journal of Emprcal Fnance, forthcomng. Poterba, James, and Lawrence Summers, 1988, Mean reverson n stock prces: Evdence and mplcatons, Journal of Fnancal Economcs 22, Rchards, Anthony J., 1997, Wnner-loser reversals n natonal stock market ndces: Can they be explaned?, Journal of Fnance 52, Rouwenhorst, K. Geert, 1998, Internatonal momentum strateges, Journal of Fnance 53, Summers, Lawrence H., 1986, Does the stock market ratonally reflect fundamental values? Journal of Fnance, 41,

20 Table I Summary Statstcs of Chnese Daly Stock Returns Ths table reports summary statstcs for daly stock returns for Chnese A shares traded n Shangha and Shenzhen Stock Exchanges. The sample covers the perod from December 12, 1990 to December 31, 2001 for 637 stocks traded at the Shangha Stock Exchange; and the perod from July 3, 1991 to December 31, 2001 for 503 stocks traded at the Shenzhen Stock Exchange. Market captalzaton fgures are for the last traded month of the sample and are denomnated n Chnese currency unt RMB. cross-secton average cross-secton std. dev. Mnmum 25 percentle 50 percentle 75 percentle Maxmum value-weghted market ndex equally-weghted mkt ndex Shangha Market mean return (%) std. dev (%) Sharpe ratox no. of obs mkt captalzaton 4.648E E E E E E E E E+09 Beta Shenzhen Market mean return (%) Std dev (%) Sharpe ratox No. of obs mkt captalzaton 3.242E E E E E E E E E+09 Beta

21 Table II Performance of Pure Momentum Portfolo Swtchng Strateges: Shangha A Shares Ths table reports the mean returns (annualzed) and t-ratos of Max, Mn, Max-Mn, Max-vw Market, and Max-ew market portfolos, where Max s the top decle portfolo, Mn s the bottom decle portfolo, and vw Market and ew Market are the value-weghted and equally-weghted averages of all A shares traded at the Shangha Stock Exchange. The strateges consdered are pure momentum strateges descrbed n Jegadeesh and Ttman (1993). J denotes the number of momentum lags, and K denotes the holdng perod. The sample covers the perod from December 12, 1990 to December 31, 2001 wth 2732 daly returns observatons and 637 stocks. Forecastng starts on July 15, 1994 and ends on December 12, 2001 wth 1823 tradng days. Numbers talczed and n bold face denote statstcal sgnfcance at the 10% level or better usng a 2-sded test. K=1 day K=1 week K=1 month K=3 month K=6 months K=9 months K=12 months Mean t-rato mean t-rato mean t-rato mean t-rato mean t-rato mean t-rato mean t-rato J=1 week Max Max-mn Max-vw mkt Max-ew mkt J=1 month Max Max-mn Max-vw mkt Max-ew mkt J=3 months Max Max-mn Max-vw mkt Max-ew mkt J=6 months Max Max-mn Max-vw mkt Max-ew mkt J=9 months Max Max-mn Max-vw mkt Max-ew mkt J=12 months Max Max-mn Max-vw mkt Max-ew mkt

22 Table III Performance of Pure Momentum Portfolo Swtchng Strateges: Shanzhen A Shares Ths table reports the mean returns (annualzed) and t-ratos of Max, Mn, Max-Mn, Max-vw Market, and Max-ew market portfolos, where Max s the top decle portfolo, Mn s the bottom decle portfolo, and vw Market and ew Market are the value-weghted and equally-weghted averages of all A shares traded at the Shanzhen Stock Exchange. The strateges consdered are pure momentum strateges descrbed n Jegadeesh and Ttman (1993). J denotes the number of momentum lags, and K denotes the holdng perod. The sample covers the perod from July 3, 1991 to December 31, 2001 wth 2615 daly returns observatons and 503 stocks. Forecastng starts on July 15, 1994 and ends on December 12, 2001 wth 1816 tradng days. Numbers talczed and n bold face denote statstcal sgnfcance at the 10% level or better usng a 2-sded test. K=1 day K=1 week K=1 month K=3 months K=6 months K=9 months K=12 months mean t-rato mean t-rato mean t-rato mean t-rato mean t-rato mean t-rato mean t-rato J=1 week Max Max-mn Max-vw mkt Max-ew mkt J=1 month Max Max-mn Max-vw mkt Max-ew mkt J=3 months Max Max-mn Max-vw mkt Max-ew mkt J=6 months Max Max-mn Max-vw mkt Max-ew mkt J=9 months Max Max-mn Max-vw mkt Max-ew mkt J=12 months Max Max-mn Max-vw mkt Max-ew mkt

23 Table IV Performance of Parametrc Portfolo Swtchng Strateges: Shangha A Shares Mean Reverson wth Momentum Ths table reports the mean returns (annualzed) and t-ratos of Max, Mn, Max-Mn, Max-vw Market, and Max-ew market portfolos, where Max s the top decle portfolo, Mn s the bottom decle portfolo, and vw Market and ew Market are the value-weghted and equally-weghted averages of all A shares traded at the Shangha Stock Exchange. The strateges consdered are pure mean reverson and mean reverson wth momentum. J denotes the number of momentum lags, and K denotes the holdng perod. The sample covers the perod from December 12, 1990 to December 31, 2001 wth 2732 daly returns observatons and 637 stocks. Forecastng starts on July 15, 1994 and ends on December 12, 2001 wth 1823 tradng days. Numbers talczed and n bold face denote statstcal sgnfcance at the 10% level or better usng a 2-sded test. K=1 day K=1 week K=1 month K=3 months K=6 months K=9 months K=12 months Mean t-rato Mean t-rato mean t-rato mean t-rato mean t-rato mean t-rato mean t-rato J=0, pure mean reverson Max Max-mn Max-vw mkt Max-ew mkt J=1 week Max Max-mn max-vw mkt max-ew mkt J=1 month Max Max-mn max-vw mkt max-ew mkt J=3 months Max Max-mn max-vw mkt max-ew mkt J=6 months Max Max-mn max-vw mkt max-ew mkt J=9 months Max Max-mn max-vw mkt max-ew mkt J=12 months Max Max-mn Max-vw mkt Max-ew mkt

24 Table V Performance of Parametrc Portfolo Swtchng Strateges: Shenzhen A Shares Mean Reverson wth Momentum Ths table reports the mean returns (annualzed) and t-ratos of Max, Mn, Max-Mn, Max-vw Market, and Max-ew market portfolos, where Max s the top decle portfolo, Mn s the bottom decle portfolo, and vw Market and ew Market are the value-weghted and equally-weghted averages of all A shares traded at the Shanzhen Stock Exchange. The strateges consdered are pure mean reverson and mean reverson wth momentum. J denotes the number of momentum lags, and K denotes the holdng perod. The sample covers the perod from July 3, 1991 to December 31, 2001 wth 2615 daly returns observatons and 503 stocks. Forecastng starts on July 15, 1994 and ends on December 12, 2001 wth 1816 tradng days. Numbers talczed and n bold face denote statstcal sgnfcance at the 10% level or better usng a 2-sded test. K=1 day K=1 week K=1 month K=3 month K=6 months K=9 months K=12 months Mean t-rato mean t-rato mean t-rato mean t-rato mean t-rato mean t-rato mean t-rato J=0, pure mean reverson Max Max-mn Max-vw mkt Max-ew mkt J=1 week Max Max-mn max-vw mkt max-ew mkt J=1 month Max Max-mn max-vw mkt max-ew mkt J=3 months Max Max-mn max-vw mkt max-ew mkt J=6 months Max Max-mn Max-vw mkt Max-ew mkt J=9 months Max Max-mn Max-vw mkt Max-ew mkt J=12 months Max Max-mn Max-vw mkt Max-ew mkt