• Do pervasive economic factors explain momentum?

      Chen, Lemeng; Faculty of Business Programs
      This thesis investigates the relationship between the profitability of momentum strategies and macroeconomic variables associated with the business cycles. We hypothesize that momentum is a risk factor that correlates with economic dynamics, which drive stock prices. We apply the two-state Markov regime switching model of Hamilton (1989) to capture the dynamic behavior of the time series of momentum return across different regimes. We include both univariate and multivariate regressions to examine the explanatory power of independent variables during different states. Moreover, we explore whether economic dynamics and investor sentiment are the only sources of the pricing effect of momentum. We adjust the momentum returns for selected macroeconomic variables, risk factors and proxy for investor sentiment. We define the residuals from the model as “pure momentum” and test the pricing capability of pure momentum in a standard asset pricing model. Using a sample of monthly data of US market covering the period between August 1962 and December 2014, we document that macroeconomic factors, risk factors and investor sentiment are unable to fully explain the momentum profits. Using a sample of monthly return on portfolios constructed by double-sorting stocks on size and book-to-market equity ratio, which include NYSE, AMEX, and NASDAQ stocks, we show that the pricing capability of momentum cannot be entirely explained by macroeconomic variables, risk factors and investor sentiment.