We examine time variations of the expected momentum profits using a two-state Markov switching model with time-varying transition probabilities to evaluate the empirical relevance of recent rational theories of the momentum profits. We find that in the expansion state the expected returns of winner stocks are more affected by aggregate economic conditions than those of loser stocks, while in the recession state the expected returns of loser stocks are more affected than those of winner stocks. Consequently, the expected momentum profits display strong procyclical variations. We argue that the observed momentum profits are realizations of such expected returns and can be interpreted as the procyclicality premium. We also find the economic significance of out-of-sample predictability of the momentum profits particularly for loser stocks and during the recession states.
Keywords: Momentum; Time-varying expected returns; Markov switching regression model; Business cycle; Procyclicality
