Contrarian and Momentum Strategies in Germany

Two traditional methods of managing equity portfolios are investing based on price momentum and value-based contrarian investing. These strategies may be motivated by a behavioral theory of under- and overreaction to news or by empirical research, mostly for the NYSE, that has found persistence in price movements over short horizons and reversion to the mean over longer horizons. However, the apparent success of these strategies may be due to institutional factors and the mismeasurement of risk, or it may result from data mining. For these reasons, we studied all major German companies listed on the Frankfurt Stock Exchange for the three decades between 1961 and 1991. The dynamics of stock prices in Frankfurt are remarkably similar to New York. The data suggest that equity prices reflect investor forecasts of company profits that are predictably wrong. Two traditional methods of managing equity portfolios are investing based on price momentum and value-based contrarian investing. We can justify these strategies with a behavioral theory of under- and overreaction to news or with empirical research for the United States that finds persistence in price movements over short horizons and reversion to the mean over longer horizons. Still, the seeming success of these strategies may be an illusion (the product of data mining), the result of the mismeasurement of risk, or the result of institutional factors that are unique to the United States.We studied all major companies listed on the Frankfurt Stock Exchange for the three decades between 1961 and 1991. We used return and accounting data for 357 firms. Nearly every German company whose name is internationally recognized (e.g., Deutsche Bank, Daimler-Benz, Bayer) was included in the sample. To judge the profitability of momentum strategies, we “bought” portfolios of extreme past winners. We also “sold” short portfolios of extreme past losers. Companies were sorted into winners and losers on the basis of their returns over the past 1, 3, 6, or 12 months (the rank period). We studied the performance of past winners, past losers, and arbitrage portfolios for the next year (the test period). To judge the profitability of contrarian strategies, we bought extreme past losers and we sold extreme past winners. Both the rank and test periods were five years long for this part of the study.The momentum and contrarian investment strategies all apparently beat a passive indexing strategy. The magnitude of the results was similar to what has been observed in the United States. For instance, zero-investment arbitrage contrarian portfolios (with the top 20 prior winners bought and the top 20 prior losers sold short) earned, on average, cumulative five-year test period returns of 21.7 percent. The results, which were driven by the exceptional performance of the prior losers, may be economically meaningful—especially because contrarian strategies require only limited trading. The momentum strategies also produced profits that may be substantial enough to be of interest to portfolio managers.We tried to reconcile the results with standard theories, but factors such as beta, risk, and firm size do not easily account for the findings. The evidence suggests, instead, that equity prices reflect forecasts of company profits that are predictably wrong.From the viewpoint of behavioral finance, what is most surprising is how closely the results for Germany match the findings for the United States—despite profound differences in the social, economic, and financial environment. Perhaps general traits in human behavior and psychology overcome these differences and ultimately drive the speculative dynamics of asset prices in world financial markets.