Issues in International Market Level Return Predictability
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Research activity in the area of return predictability has increased in the last decade. Momentum and contrarian studies have mostly targeted the return predictability of individual stocks, with fewer studies investigating the predictability of international stock market index returns. The overall aims of the thesis are to determine whether it is possible to predict future international index returns, and to assess whether any predictability found can be adequately explained either by traditional asset pricing or by existing behavioural theories. Using a data sample of 49 developed and emerging market indices from 1970 to 2006, this study examines the profitability of momentum strategies, contrarian strategies, strategies based on the volatility of past returns, and strategies based on the 52wk high ratio. In addition, this thesis investigates the interaction of momentum and contrarian strategies with each other and with volatility to assess the profitability of new combined strategies. The findings show that momentum and contrarian effects are present in international stock market indices, confirming previous index-level research. Unlike previous results at the stock level that showed that the Fama and French three-factor model is able to explain contrarian profits, the contrarian effect at the index level survives risk adjustment. Consideration of joint momentum/contrarian effects reveals highly profitable trading strategies that are superior to the individual momentum and contrarian strategies. Moreover, the results of these combined strategies support the notion that momentum and contrarian effects are integrated. The investigation of early stage and late stage momentum strategies indicates that the most likely explanation of momentum profits is that they are partly due to underreaction to past long-term overreaction and partly due to delayed overreaction. This important result means that none of the existing behavioural theories of momentum provide an adequate explanation of momentum. The thesis also investigates whether contrarian profits can be improved by taking into consideration the short term performance of indices. This novel approach finds that the double-sorted late stage contrarian strategies are superior to single-sorted contrarian strategies in both the developed and emerging settings. This study also demonstrates that past index volatility can be used as a variable, either on its own or in combination with past returns, to predict future index returns. Using past volatility of returns to create single-sorted volatility strategies (long high volatility and shorting low volatility) produces strikingly different results in emerging markets compared to developed markets. Remarkably, a portfolio based on past high volatility emergin indices produces the highest risk-adjusted returns (exceeding 21% annualized) found in this thesis. The double return/volatility strategy analysis reveals that volatility fails to enhance the momentum or contrarian effect in the developed markets, while in the emerging countries volatility significantly improves the pure momentum and contrarian strategies returns. Interestingly, the zero cost momentum/ volatility risk-adjusted profits exceed 21% per annum in the emerging markets case. The analysis of the ability of the 52wk high ratio to predict future index returns shows that, in contrast with previous research, the 52wk high ratio effect is neither strong nor reliable at the aggregate international market level. The 52wk high strategy applied to index returns produces weak but significant results in the developed markets but the strategy loses money in the emerging markets. The 52wk high strategy also has insignificant profits when applied to all 49 indices. Overall, this lack of profitability suggests that perhaps international index investors do not focus on indices’ 52wk high levels.
Thesis (PhD Doctorate)
Doctor of Philosophy (PhD)
Department of Accounting, Finance and Economics
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behavioural theories of momentum