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Momentum strategies usually do not produce significant profits in emerging stock markets. Chui, Titman, and Wei [Chui, A. C. W., Titman, S., & Wei, K. C. J. (2000). Momentum, legal systems and ownership structure: An analysis of Asian stock markets. Working paper, Hong Kong Polytechnic University, Chui, A. C. W., Titman, S., & Wei, K. C. J. (2006). Individualism and momentum around the World. Working Paper, Hong Kong Polytechnic University] argue that the lack of profitability is due to cultural differences. In this paper, we look at one of the largest emerging markets, the Taiwan stock market. We find that DOWN markets occur more frequently and momentum profits are more negative following DOWN markets in Taiwan than in the US. Taken together, our findings suggest that the lack of profits from momentum strategies in emerging markets may be due more to the state-dependence of momentum discovered by Cooper, Gutierrez, and Hameed [Cooper, M. J., Gutierrez R. C., & Hameed, A. (2004). Market states and momentum. Journal of Finance, 59, 1345–1365] rather than to cultural differences.

Cooper, Gutierrez and Hameed (2004) (CGH) argue that the behavioral models of Daniel, Hirshleifer and Subrahmanyam (1998) (DHS) and Hong and Stein (1999) (HS) imply that momentum profits depend on the market state: momentum profits should be strong following “UP” states and weak following “DOWN” states.2 They find supporting evidence of this relationship in the US data. From 1929 to 1995, about 84% of their sample months are in UP states and 16% in DOWN states (based on the 36-month measurement interval), and the mean momentum profit is 0.93% per month following UP market states but −0.37% following DOWN states. In this paper, we hypothesize that the state-dependence of momentum profits discovered by CGH may explain an interesting yet not well-studied issue in the momentum literature: Why is momentum usually weak in emerging markets but strong in developed markets? The mean momentum profit (based on the six-month/six-month strategy) is 0.95% per month for the US market Jegadeesh and Titman (1993), and on average 0.91% per month for 12 European markets with only one national market having statistically insignificant momentum profits [Rouwenhorst (1998)].3 In contrast, only 6 out of 20 emerging markets exhibit momentum profits (average 0.39% per month) [Rouwenhorst (1999)]. Further, none of the six Asian emerging markets evidenced significant momentum profits [Chui, Titman and Wei (2000)]. This profitability difference between emerging and developed markets is interesting, because it seems to pose a serious challenge to popular behavioral models used in, for example, DHS and HS to explain momentum.4 If DHS and HS are correct concerning cognitive investor biases or gradual information diffusion as the driving force of momentum, this profitability difference between developed and emerging markets would seem to imply that either information is better in emerging markets or investors in emerging markets have less cognitive bias. The first position is clearly not persuasive. As Chan and Hameed (2006) point out, emerging markets (compared to developed markets) usually have poorer information because there are fewer regulations and less enforcement of information disclosure, and lower degrees of voluntary disclosure and corporate transparency. The second view of less cognitive bias in emerging markets has received support from Chui et al., 2000; Chui, Titman and Wei (2006). They argue that certain cultural or institutional structures in emerging markets may lead to less overconfidence/cognitive bias and therefore weaker momentum. However, a recent study by Bohl and Siklos (2004) shows that feedback-trading strategies yield greater profits in emerging stock markets. This indicates that investors in emerging markets may be more irrational or have greater cognitive bias than those in developed markets.5 Therefore, the idea of less cognitive bias in emerging markets is not convincing either. In this paper, we provide an alternative explanation for the lack of momentum profits in emerging markets. We believe that this lack is due to the state-dependence of momentum discovered by CGH rather than to cultural differences discussed by Chui et al., 2000 and Chui et al., 2006 Consider the following profit decomposition, equation(1) WML=sDOWNWMLDOWN+sUPWMLUPWML=sDOWNWMLDOWN+sUPWMLUP Turn MathJax on where WML denotes the overall momentum profit; WMLDOWN and WMLUP denote the momentum profits following DOWN and UP states, respectively; and SDOWN and SUP denote the percentages of the sample in DOWN and UP states, respectively. If there are more DOWN states, and/or if momentum strategies generate stronger negative profits following DOWN markets in emerging markets, it is likely that standard momentum strategies would be unprofitable. Emerging markets may have more DOWN states due to lack of maturity. A study of stock market crises in developed and emerging markets by Patel and Bohl (1998) supports this position. They find that out of nine crises for the period 1970–1997, six occurred in emerging markets. Momentum strategies may generate stronger negative profits following DOWN states in emerging markets if the DOWN market is more severe. More severe DOWN markets reduce the level of investor overconfidence (DHS), and increase the level of investor risk aversion (HS) to a greater extent. As a result, investors have weaker overreaction/delayed overreaction. Consequently, correction or return reversals may take place more rapidly, and momentum profits may be more negative.6Patel and Bohl (1998) support this position. They find that, for emerging market crises, prices tend to fall steeply and take longer to recover compared to developed markets. We test our hypothesis using the Taiwan stock market data. We find strong evidence favoring state-dependence of momentum in the Taiwan stock market. This finding explains why the Taiwan stock market does not exhibit momentum profits. First, the mean momentum profit following DOWN market states is more negative (−1.44% per month in Taiwan in contrast to −0.37% per month in the US market). Furthermore, there are more DOWN states in the Taiwan stock market than in the US. About 35% of the Taiwan sample months are in DOWN market states, while only about 16% of the US sample months are in DOWN states. Taken together, these two factors explain why standard momentum strategies are not profitable in the Taiwan stock market. We also find that the mean momentum profit following UP markets in Taiwan is 1.14% per month, which is not smaller than the 0.93% profit found in the US (CGH). Strong momentum following UP markets in Taiwan does not support the idea that investors in the Taiwan market have less overconfidence or cognitive bias as Chui et al., 2000 and Chui et al., 2006 suggest. If they were correct, momentum following UP markets in the Taiwan market would be weaker than that in the US market. Our results are more consistent with Patel and Bohl (1998), and suggest that investors in emerging markets are not more rational. Therefore, the unprofitability of momentum strategies in emerging markets may be due more to the state-dependence of momentum rather than to cultural differences. Our findings, therefore, suggest that investor behavior in emerging markets (such as the Taiwan market) is not fundamentally different from that in developed markets. In both types of markets, strong overreaction following UP markets generates strong price continuation, while weak overreaction following DOWN markets produces weak price continuation. Overreactions eventually are corrected. Therefore, price continuation is always followed by a reversal. What causes the unprofitability of momentum in emerging markets is the frequency and severity of DOWN markets rather than different investor behavior in these markets. Therefore, as soon as the state-dependence of momentum is taken into account, weak momentum in emerging markets is not inconsistent with the behavioral models of DHS and HS. The remainder of the paper is organized as follows: Section 2 describes the data and the empirical methodology. Section 3 investigates the relationship between market states and momentum in the Taiwan stock market. Section 4 concludes the manuscript.

Momentum is usually weak in emerging markets but strong in developed markets. Chui et al., 2000 and Chui et al., 2006 argue that this profitability difference is due to cultural differences. We show in this paper that the lack of profitability of momentum strategies in emerging markets (such as the Taiwan market) is due more to the state-dependence of momentum discovered by CGH rather than to cultural differences. This conclusion is based on two key findings. First, the mean momentum profit following UP markets in Taiwan is strongly positive. This finding does not support the idea that the investors in the Taiwan market are less overconfident or exhibit less cognitive bias, as Chui et al., 2000 and Chui et al., 2006 suggest. Second, the mean momentum profit following DOWN markets in Taiwan is strongly negative, and there are many DOWN states in Taiwan. Taken together, these explain why standard momentum strategies are not profitable in the Taiwan stock market. Our results have important investment implications. Investors in both developed markets and emerging markets could improve their investment performance by using a conditional, not an unconditional, momentum strategy. That is, investors should follow a momentum strategy when the prior market state is UP, and a contrarian strategy when the prior market state is DOWN. This is more true to emerging markets due to the frequency and severity of DOWN markets in emerging markets.