Momentum is still there conditional on volatility-amplified pessimism

Abstract

We present a representative agent model with probability weighting that predicts expected momentum returns decrease in market volatility and pessimism, and predicts the opposite for the equity premium. Hence, the model predicts that the expected market and momentum returns move in opposite directions and can be used to form a dynamic hedging strategy that conditions on market volatility and market pessimism. Our asset pricing model motivates an index of volatility-amplified pessimism (VAP) that predicts both momentum and market returns as well as a real-time trading strategy that uses the index to switch between the market and momentum portfolios. In high VAP states, the market generates high returns and Sharpe ratios, while momentum generates high returns and Sharpe ratios in low VAP states. Although most momentum strategies have recently disappeared we find that momentum is still there, conditional on the interaction between market pessimism and market volatility.