Momentum is one of the bets know and consistent risk premium in the finance factor zoo. The strategy us simple. Sort the returns of some stock universe and buy the top winners and sell the losers. It is not considered part of the five factor "holy grail", yet there may still exist some puzzling results. Foremost the times series of returns from this factor are highly variable. While consistent in the long-term, there are periods of poor performance.
An interesting piece of research has been published that tries and explain the time variation in momentum based on the dispersion or gap between the winners and losers. It has been called the momentum gap. See "The Momentum Gap and Return Predictability" by Simon Huang.
The momentum gap negatively predicts momentum profits. This applies to both the US and international stock markets. If there is a one standard deviation increase in the gap, there will be predicted a 125 bps fall in monthly momentum returns even after controlling for other factor predictors.
There are several conjectures for why this momentum gap effect may occur, but a simple explanation may be best. If there is a large gap, then we have a case where the winners have significantly outperformed the losers. We are at extremes. There is a wide difference in performance which suggest that the momentum or trends that are being identified have reach extremes. It is likely that the momentum effect will be reversed. This is consistent with the fact that the momentum effect exhausted over the longer-run.
The factor price for risk changes through time and market extremes have a different risk profile. The extreme, or chance of reversal, view makes sense because this gap effect is strong for static portfolios but declines when there is dynamic monthly rebalancing. A new sorting will find a different set of long and shorts which may be break any buy or sell extremes. A large gap suggests an overreaction in momentum which may lead to a reversal or convergence. A tight gap is an environment where new information could lead to more divergence.
Mind the gap for momentum or trend portfolios.
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