As opposed to the short term momentum (Price Index 1M) and long term momentum (Price Index 5Y), the intermediate-term momentum (3M, 6M and 1Y) show a continuation in the following months. If a stock has done relatively well in the past, it will continue to do well in the future.
In a paper published in 1993, Returns to buying winners and selling losers: implications for stock market efficiency, authors Narasimhan Jegadeesh and Sheridan Titman found that strategies which buy stocks that have performed well in the past and sell stocks that have performed poorly in the past generate significant positive returns over 3- to 12-month holding periods. They also found that the abnormal returns were not long-lasting.
The stocks included in the relative strength portfolios experience negative abnormal returns starting around 12 months after the formation date and continuing up to the thirty-first month. For example, the portfolio formed on the basis of returns realized in the past 6 months generates an average cumulative return of 9.5% over the next 12 months but loses more than half of this return in the following 24 months.
In their tests, running from 1965 to 1989, selecting stocks based on their 6 month PI and holding them for 6 months realized a return of 12.01% per year on average.
We use the following formula to calculate the 6 month price index:
* The share price is adjusted for stock splits, cash dividends, right offerings and spin-offs.