Momentum, Business Cycle and Time-Varying Expected Returns

In recent years there has been a dramatic growth in academic interest in the predictability of asset returns based on past history. A growing number of researchers argue that time-series patterns in returns are due to investor irrationality, and thus can be translated into abnormal profits. Continuation of short-term returns or momentum is one such pattern that has defied any rational explanation, and is at odds with market efficiency. This paper shows that profits to momentum strategies can be explained by a set of lagged macro-economic variables and payoffs to momentum strategies disappear once stock returns are adjusted for their predictability based on these macro-economic variables. Our results provide a possible role for time-varying expected returns as an explanation for momentum payoffs