Profitability of momentum and contrarian trading strategies in the U.S. stock market

Over the past decades, investor rationality is underlined by most of the theories developed in the finance literature. In the context of the absolute rationality of the market participants, the efficient market hypothesis which has been one of the dominant sources for price prediction claims that asset prices incorporated fundamental information used by rational investors. Therefore every asset is at its equilibrium price. In such a case, any unforeseeable inconsistency in security prices is considered as an anomaly in the financial markets. These anomalies and their main drivers have attracted the interest of many financial researchers who have often agreed that not all market participants are rational. Consequently, their researchers provided a basis for a behavioral finance which is an approach that involves the models which are influenced by irrational factors more than those are considered rational. Considering the purpose of the study, it is mainly aimed to shed light on the return patterns as anomalies which are causatively connected with investment decisions of market participants and their reactions to the information. The thesis investigates the momentum and contrarian approaches comparatively on equity returns in the U.S. Stock Market. In this regard, the study analyzed whether strategies on average outperformed the benchmark of the market return, building on the filtered and corrected monthly historical data of the stocks traded in the S&P500 Index between December 1994 and January 2018. Momentum strategies focus on the portfolios that involve stocks with higher profits in the past and contrarian strategies vice versa. Correspondingly, the results show the significant profitability of momentum strategies based on various trading frequencies, even after possible transaction costs. However, it is not possible to say for contrarian strategies. For instance, the average monthly excess returns are maximized for the momentum strategy that select first 25 stocks and has 3-month observation period and 12-month holding period with a value of 4,33% at 1% significance level. In addition, the relationship between the monthly average excess returns of momentum and contrarian strategies and the turnover velocity of the market is examined. A significantly negative relationship is observed with monthly momentum profits and market turnover.