The Enigma of Momentum: Exploration of the Intricate Relationship Between Factor Momentum and Stock Momentum

Abstract

This study delves into the enduring puzzle of momentum in the sphere of factor investing, by examining the profitability of momentum, how factor momentum relates to traditional stock momentum, and how the anticipated state of the market affects factor momentum.
Through analysis of the U.S. equity market spanning six decades, this thesis documents significant ab-normal returns of both stock and factor momentum strategies, the profitability of which are concentrated in the long positions. The results are robust to altered formation periods and accompanying transaction costs, the latter of which often undermine proposed factor performance. Ultimately, the achievability of abnormal returns advocates a sustained prevalence of momentum in financial markets, contributing to the vast literature defying the efficient market hypothesis.
While the presence of stock momentum is indeed verified, the phenomenon can be fully explained by factor momentum, while the inverse causality is tested and disproven. The reported subsumption echoes previous literature (e.g. Ehsani and Linnainmaa, 2022; Fan et al., 2022; Cakici et al., 2023) and challenges momentum’s role as a distinct factor, by implying that stock momentum is an aggregation of momentum in all factors. The subsumption is condensed in high eigenvalue principal components, which show strong momentum effects and amplifies the explanatory power of factor momentum on stock momentum.
Diving into relatively unexplored facets of factor momentum, the analysis proposes a causal relationship between the anticipated sentiment of the market and factor momentum. Particularly, the return of factor momentum is elevated in times of bullish sentiment. Remarkably, sentiment is the only examined market state proxy to exhibit significant causality with factor momentum.