Momentum crashes

TLDR

Momentum strategies normally deliver strong average returns but can experience infrequent, persistent negative runs, particularly in panic states where low expected returns reflect a high premium on past losers’ option‑like payoffs. The study shows that momentum crashes are partly forecastable, occurring after market declines and during high volatility, and that a dynamic strategy based on forecasts of momentum’s mean and variance can roughly double alpha and Sharpe, with these results robust across time periods, international equity markets, and other asset classes.

Abstract

Despite their strong positive average returns across numerous asset classes, momentum strategies can experience infrequent and persistent strings of negative returns. These momentum crashes are partly forecastable. They occur in panic states, following market declines and when market volatility is high, and are contemporaneous with market rebounds. The low ex ante expected returns in panic states are consistent with a conditionally high premium attached to the option like payoffs of past losers. An implementable dynamic momentum strategy based on forecasts of momentum’s mean and variance approximately doubles the alpha and Sharpe ratio of a static momentum strategy and is not explained by other factors. These results are robust across multiple time periods, international equity markets, and other asset classes.