Nonlinear Effect of Sentiment on Momentum

Abstract

I study a Lucas economy with many trees and a representative agent with market-wide sentiment. As a result of sentiment spillovers, the agent believes that there is momentum in the cross section of asset returns. However, from the point of view of an outside econometrician, the market price of risk relates negatively to sentiment. This, together with the subjective momentum, causes returns on momentum strategies to be a concave function of sentiment, leading to a downside risk of momentum. I find empirical evidence consistent with model predictions.