Time-Varying Expected Momentum Profits

We examine the time variations of expected momentum profits using a two-state Markov switching model with time-varying transition probabilities to evaluate the empirical relevance of recent rational theories of momentum profits. We find that in the expansion state the expected returns of winner stocks are more affected by aggregate economic conditions than those of loser stocks, whereas in the recession state the expected returns of loser stocks are more affected. Consequently, expected momentum profits display strong procyclical variations. We provide a plausible explanation for time-varying momentum profits through the differential effect of leverage and growth options across business cycles