Predicting Momentum Returns

Abstract: Momentum strategies have historically shown to yield positive returns with little systematic risk exposure. Although usually profitable over long time periods, momentum strategies have also shown to suffer from irregular but severe losses that effectively erode the strategies' attractiveness. By analysing a size-restricted sample of stocks listed on the Stockholm stock exchange between 1987 and 2013 we present how to predict and exploit these losses with the risk-free interest rate as a leading indicator. By incorporating a "switching rule" that alters between momentum and reversal portfolios conditional on changes in this leading indicator, we provide a self-financing strategy that yields a monthly alpha of 0.76%, and which risk-reward profifle dominates that of the unconditional momentum strategy for two reasons; expected returns are higher and downside risk is lower.