THE ECONOMIC VALUE OF MOMENTUM AND SENTIMENTAL INDICATORS IN EQUITY TRADING: A MEAN?VARIANCE UTILITY?BASED APPROACH

Abstract

I study the economic value of momentum indicators like technical trading signals that are applied to trade sentiment sensitive cross sections of stocks. Specifically, I find out if opportunity cost exists for rational risk averse investors using technical trading rules to guide their investment decision on different characteristic portfolios of stocks. Portfolios are formed with firm characteristics that are shown to be sensitive to sentiments by Baker & Wurgler (2006). They include firm size, earnings to book equity ratio for profitable firms, dividend to book equity ratio, plant, property and equipment to asset ratio, research and development to asset ratio, book to market equity ratio and percentage sales growth. Two sets of opportunity costs are being analysed. The first set of opportunity cost is based on the relative performance of technical trading and a predictive model that rely on technical trading signals. The next set is based on the relative performance of technical trading and the one period lag version of Fama and French (1993) three factor model. I found compelling empirical evidence indicating that the opportunity costs of using technical trading rules is negative showing that the value of technical trading is actually higher than the value of econometric models.