When markets are unclear - under-reaction and momentum

Trend-following works, but that may not be a good enough reason to follow trends. There should be a strong foundation for why this strategy generates returns and the conditions when it will be effective. It may not be necessary to have these underpinnings, but it does help us understand the dynamics of an important strategy. A theoretical foundation will provide support for when trends will occur and what will be the environment for when they will not occur.

A recent issue of the American Economic Review discusses the issue of market under-reaction and shows that with some very simple assumptions, you will not move immediately to the equilibrium price when trading occurs. Markets under-react which creates the environment to identify and trade trends.

The foundation for this result is that if there are heterogeneous beliefs about the valuation of an asset, there will be under-reaction. If there is more divergence in opinion, there will be more under-reaction and hence momentum in price.  If you cannot agree on the value of an asset, it will be harder to get there fast.

Given this result, we can likely conjecture that those markets where there is greater differences in beliefs will lead to greater potential momentum. So let's see if we can classify markets based on which ones may have more dispersion in beliefs.

• If a market is harder to model or determine fair value, there will likely be greater belief differences.  These markets will have a slow adjustment to equilibrium.
• If there is high volatility, which could be a simple measure of market uncertainty, there should be more under-reaction.
• If there is more dispersion in information about an assets, there will be greater differences in beliefs.
• There will be more under-reaction if there are significant changes in wealth that affect levels of risk aversion for the average and marginal investor.
• As beliefs are realized to be either true or false from the introduction of public information, there will be under-reaction or adjustment. 

My conjecture is that makes traded in a global macro portfolio are more likely to see momentum. The foreign exchange markets have all of the hallmarks of an asset class that will have strong differences in beliefs. The same applies to commodities. Equities may have less differences given that we can find arbitrage relationships with similar firms. Bonds markets also may be likely to see greater differences. The same with stock indices which are harder to value than an individual stock.

As long as there are differences in opinion, there will be under-reaction and trends. If we see more uncertainty which causes greater differences in beliefs, we will see more trend behavior.