Economic policy uncertainty and momentum

Abstract

We show that a news‐based measure of economic policy uncertainty (EPU) negatively forecasts momentum. A 1‐standard‐deviation increase in EPU is associated with a 1.11% decrease in risk‐adjusted momentum returns. The predictive power of EPU is robust after controlling for previously documented economic state variables and macroeconomic uncertainty. We provide an explanation for these results from the perspective of a fund flow‐induced trading mechanism and offer direct empirical support. The literature documents that momentum can be partially attributed to performance‐chasing mutual fund flows. We find that this flow‐induced mechanism functions more effectively in low EPU states, thereby generating stronger stock momentum.

Momentum strategies in times of economic policy uncertainty

“…Based on the above, in this paper it has been proposed to analyse the possible influence of the uncertainty related to economic policies, EPU, on the profits generated by momentum strategies. Although studies such as those by Gu et al (2019) have investigated this possible influence, the role of the economic cycle and different quantiles in this relationship have not been assessed.…”

“…Works such as Addoum and Kumar (2016) propose future research to examine the influence of the political climate on the profits generated by momentum strategies, suggesting that a significant portion of those profits could be associated with political interest. Along these lines, following Lou (2012) in his proposal of the mechanism based on the flow of funds to understand the momentum effect, and Starks and Sun (2016), who show that investors’ learning about fund performance signals weakens when EPU increases, Gu et al (2019) argue that the performance-chasing mutual fund flows can lead to winning stocks exceeding losing stocks only in the state of low EPU, leading to significant profits from the momentum effect. Under this assumption, these authors found that EPU predicts the profits of the momentum effect negatively.…”

“…Because of the influence shown of the three-factor model of Fama and French (1992) on stock returns, the three factors of this model have been taken as control variables, following Cheema and Nartea (2014), Zhang (2006), Chen et al (2019) and Gu et al (2019), among others. The three factors used are: value weighted market return ( MKT ), the difference between the performances of high and low value stocks ( HML ) and the difference between the performances of small- and big-sized stocks ( SMB ).…”

“…Among the several anomalies that demonstrate the inefficiency of financial markets, the momentum effect identified by Jegadeesh and Titman (1993) is considered the most robust and best known anomaly in the financial literature (Gu et al , 2019). This effect demonstrates that those stocks with high returns in the past 3–12 months (winners) have abnormally higher returns over the following 3–12 months than those stocks that had low returns in that period (losers).…”

“…The aim of this research is to respond to the gap found in the literature. Although studies such as those by Gu et al (2019) have investigated the possible influence of EPU on the profits generated by momentum strategies, the role of the economic cycle and the use of different quantiles in this relationship have not been assessed. This study is the first work that in addition to determining whether or not there is an influence of EPU on the momentum effect, analyses this influence based on the economic cycle and different quantiles.…”