Profitability of Contrarian vs Momentum Strategies: Evidence from the Istanbul Stock Exchange

Financial academics and practitioners have recognized that average stock returns are related to past performance and cross-section of stock returns is that predictable based on past returns. Number of researchers report that past losers (negative or lowest return-stocks) outperform past winners (positive or highest return-stocks) or vice versa over the subsequent three to five years not only in US markets but also in other stock markets. This study examines the momentum and contrarian effects on stock returns in one of the leading emerging markets, Istanbul Stock Exchange (ISE) between years 1991 and 2000 by using the same empirical methodology in Jegadeesh and Titman (1993). It also investigates the weak-form efficiency of the stock market by examining the profitability of a number of contrarian strategies based on past prices, size, price, book-to-market, earnings-to-price ratios of stocks. Prior loser-stocks are found to outperform prior winner-stocks consistent with the predictions of the overreaction hypothesis. Compounded annual return difference between the top-winners and top-losers is around 15% in favor of loser-stocks since the average return difference during the 10-year period is 1.14% per month. Empirical findings for the longer-term average returns up to 36 month holding periods reveal a reversal of returns from 15 months to 36 months. On the other hand, we find that average abnormal returns and the average abnormal return difference per month between losers and winners increase as the holding period extends. Results also indicate that there is a downward trend in average returns for the winner stocks based upon the length of past returns that is used for portfolio formation but upward trend for the losers. Profitability of the strategies is robust to changes in the size of the portfolios. We also find that contrarian profits in January are significantly higher than those in non-January months, particularly for the short-term holding periods such as one and three months, however, losers outperform the winners in most of the months of the year. The overreaction is significantly stronger for smaller firms than for larger firms. Losers portfolio are typically smaller, lower priced, high-B/M and high-E/P stocks (as distressed stocks) than stocks in the winners portfolio. Our evidence indicates that there is significant price, size, B/M and E/P effects in stock returns in ISE, consistent to previous empirical work. After we analyzed 80 different strategies based on five different factors such as past-return, size, price, B/M and E/P, in various length of formation and holding periods, we find that stocks that have lower price, smaller size, lower past-return, higher-B/M and E/P are significantly provide higher returns than others. Price, size and E/P-based portfolios earn a larger return than loser-winner portfolios suggested by the overreaction hypothesis. Large profits of winners&losers portfolios might be subsumed or caused by the other factors such as size, E/P and B/M effects. It might most probably be size-based phenomenon with the contribution of other factors. On the other hand, findings show that losers are riskier than the winners because they are more sensitive to all three Fama-French factors, however, significant contrarian profits are partially related with risk factors and not captured by the three-factor model of Fama and French. Large abnormal returns of winner and loser portfolios and overreaction effects might be explained only in part by the risk factors. Finally, our results show that contrarian effects or more specifically "winners and losers effect" are existing on stock returns in ISE and the contrarian trading strategies that is buying past losers and selling past winners realize significant abnormal profits to the investors consistent to DeBondt and Thaler (1985). However the evidence is also consistent with the overreaction and partially with the behavioral hypothesis and risk, reasons behind the profitability of the contrarian strategies needs to be scrutinized by using new explanatory risk factors and hypothesis.