Using data from the Shenzhen and Shanghai stock markets Chun-Da Chen, Chiao-Ming Chen and Riza Demirer from the Lamar University (Texas), ZhiDao Financial Services and the Southern Illinois University respectively set out to test if oil price volatility had any predictive power for stocks when combined with a simple momentum strategy?
They finger momentum as one of the most curios anomalies observable in just about every stock market i.e. the fact that things tend to go in the same direction for longer than the underlying fundamentals suggest they should. In theory, any effect that is observable and persistent should disappear over time as smart folks squeeze the juice out of these ‘obvious’ anomalies.
In practice though economic and financial market theories often fail to take into account the human element. Many people, including those operating in stock markets, regularly and persistently do things known to have bad economic payoffs. The evidence is all around; casinos, cigarette smoking, speeding, tattoos, bitcoin. Take your pick.
What the researchers discovered here was that an increase in oil price volatility causes investors to herd into ‘safe’ stocks. As a result the safe stocks become overpriced which, as every schoolchild knows, leads to poor performance over the longer term. A strategy of buying losers and selling winners after a bout of increased oil price volatility therefore adds as much as 2% per month over what a simple momentum strategy would produce. It also works the other way i.e. when oil price volatility falls buy winners and sell losers.
What the authors don’t do is address the real-world problems that often make these strategies fine on paper but hard to put to work in practice. Liquidity, frictional costs, financing and borrow (or usually the lack thereof) usually scupper attempts to work these plans and that’s precisely why they persist.
What this paper may usefully contribute though is a better ‘fear-guage’ than observed volatility of stocks or the market in which they’re traded? What it also reminds is the simpler lesson that paying fancy prices for stocks is neither the fun nor profitable way to invest in the long run.
Holders of Tencent, Alibaba, AAC Acoustic and Sunny Optical should take note. That’s if they’re reading this and not currently speeding to a casino to wager bitcoin puffing on a Marlboro-light fresh out of their favorite tattoo shops?
You can access the paper in full via this link Oil and Stock Market Momentum.
Happy Sunday.