Momentum, Credit Risk and Business Cycles

Abstract

We investigate the link between momentum returns, credit ratings, and business cycles. Momentum returns are significant and large in speculative-grade stocks and more so during contraction periods in business cycles. Speculative-grade stocks, on average earn momentum returns of 1.71% per month during expansions. During contractions they earn on average 4.12% per month. Momentum returns are not observed in investment-grade stocks during market expansions and are 1.62% per month during contractions. Momentum returns cannot be explained by idiosyncratic risk factors. However, they disappear when we control for macroeconomic risk factors. Term spreads and default spreads are significant in explaining momentum returns. Momentum returns are compensation to investors for high business risk and high uncertainties in the economy during economic downturns. Momentum returns are greater for highly ambiguous and volatile stocks (Jiang, Lee, and Zhang (2005) and Zhang (2006)). Zhang (2006) measures ambiguity with the arrival of public information and shows that momentum profits in these stocks remain unexplained when return volatility, cash flow volatility, market capitalization, and analysts earnings forecast dispersion are taken into account. Avramov, et al (2007) show momentum returns are high among low-grade firms and are nonexistent among high-grade firms. Their results imply that momentum returns should be higher during recessionary periods when credit risk is high. However, their time series analysis indicates otherwise. This is puzzling. They also advise that “future work should address” this issue (Avramov et al (2007), p. 2520). In this paper, we do that. We show that momentum returns are earned mainly by speculative-grade stocks during recessions. Speculative-grade stocks carry high uncertainty in terms of company prospects. During recessions, credit risk is a major concern and imposes additional uncertainty. Momentum returns compensate for both the credit risk of a company and the economic environment.