The Momentum Gap and Return Predictability

Abstract

The formation period return difference between past winners and losers, which I call the momentum gap , negatively predicts momentum profits. I document this for the U.S. stock market and find consistent results across 21 major international markets. A one-standard-deviation increase in the momentum gap predicts a 1.25 % decrease in the monthly momentum return after controlling for existing predictors. This predictability extends up to 5 years for static momentum portfolios, consistent with time-varying investor biases. Following the simple real-time strategy of investing in momentum only when the momentum gap is below the 80th percentile delivers a Sharpe ratio of 0.78.