Momentum and Market Instability

Abstract

This paper establishes a strong link between the profitability of the momentum strategy and market instability, as gauged by flight-to-quality episodes. Momentum gains are shown to be roughly ten times larger during flight episodes. Further, flights are significantly associated with larger momentum profits even after controlling for indicators of asset performance, volatility, illiquidity, market state, and monetary policy. This paper's results also show that illiquidity shocks appear to diversely affect different types of flights, as predicted in Vayanos (2004). Finally, monetary policy announcements, past and contemporaneous, are shown to decrease the incidence of market instability.