Aggregate profit instability and time variations in momentum returns: Evidence from China

Abstract

This study investigates the predictive power of aggregate profit instability for time variations in momentum returns. We find that aggregate profit instability has significantly negative predictive power for momentum returns. This predictive power is asymmetric depending on the market state. Specifically, it is prominent in an UP market state but significantly decreasing in a DOWN market state. This asymmetric predictive pattern persists even after we control for traditional factors that influence time variations in momentum returns. Furthermore, based on unanticipated aggregate profit instability, we explore the source of momentum returns and find that the negative risk price of unanticipated aggregate profit instability is an important source for positive momentum returns; this finding is consistent with the risk compensation explanation for the momentum effect. Lastly, inspired by the empirical results, we suggest the following intuitive explanation for the predictability of momentum returns: in the Chinese stock market, the predictability of momentum returns can be attributed to the time-varying proportion of speculators, which could also be influenced by aggregate profit instability in the market.