Earnings expectations, prices and slow reaction - The opportunity for momentum

 

What is now a current theme in finance to explain the slow reaction in prices and the opportunity for momentum profits is the idea of inattention. Investors are slow to react to news and thus slow to adjust prices which leads to trends. There is something missing about this argument. Investors seems to be inattentive, yet it begs the question of why would you be so inattentive and why don't machines just do the watching? 

We will forgo this discussion and focus on some interesting research, "Earnings Expectations and Asset Prices". The researcher's focus on analysts' earnings expectations and find that they generally under-react to news, but the under-reaction declines during high volatility periods. However, the degree of under-reaction has fallen over time. These stylized facts on earnings, assumed to be caused by inattention, can spillover to behavior of markets. 

If earnings expectations are slow to adjust there will be momentum in markets. When the adjustments do occur, especially in higher volatility environments, there is the potential for momentum crashes. Hence, there is a reason for switching in momentum look-backs based on the volatility regime. Use longer loopbacks under normal times, and short loopbacks during more volatility times. A mixed momentum strategy makes sense. Of course, this paper provides many more insights, but it does a good job of linking the inattention to new information on expectations which creates an environment where momentum works. However, the profits from momentum trading will be linked with the adjustments of inattention by market participants.