Momentum, Information Uncertainty, and Leverage - An Explanation Based on Recursive Preferences

Abstract

Past work suggests that momentum is among the most robust market anomalies, as well as momentum profitability concentrates in firms with high information uncertainty and high credit risk. This paper shows that such momentum concentrations naturally emerge in an equilibrium setting with mean-reverting dividend growth, persistent expected dividend growth, recursive preferences per Duffie and Epstein (1992), and leverage based on Abel (1999). In particular, when the representative agent is endowed with reasonable riskaversion and time preferences parameters, equilibrium momentum profitability is large in the interaction between high levered and risky cash flow firms. Momentum payoffs rapidly deteriorate and ultimately disappear as either leverage or cash flow risk diminishes.