Catching the Turn: Improving Momentum Performance Through Reversal Timing

Abstract

This thesis investigates momentum investing strategies in U.S. equity markets from 1985 through 2024, examining the persistence of the momentum effect, the characteristics of its crashes, and the efficacy of dynamic contrarian strategies in mitigating downside risk. The study confirms that while the momentum anomaly, defined by buying past winners and selling past losers, continues to generate significant excess returns and CAPM alphas, its profitability is time-varying and methodology-sensitive. A key finding is the asymmetric contribution to momentum alpha, which is largely driven by the pronounced underperformance of the past losers. Further, the findings reveal that momentum strategies are susceptible to infrequent yet severe crashes, characterized by large drawdowns and negative skewness, typically occurring during sharp market rebounds following crises. The evidence links these crashes to the momentum portfolio’s time-varying beta, which becomes strongly negative during such periods. Addressing this vulnerability, the thesis explores dynamic strategies that switch from a standard momentum position to a contrarian one based on market-based signals (significant market declines) or VIX-based signals (spikes in market volatility). Empirical results demonstrate that these dynamic approaches, can substantially enhance risk-adjusted returns, reduce maximum drawdowns, and improve return skewness compared to a static momentum strategy.The findings suggest that momentum still persists as a challenge to market efficiency. Additionally, the inherent crash risk is shown to be substantially mitigated through adaptive strategies that respond to prevailing market conditions, thereby improving the overall resilience and performance of momentum investing.