Information Percolation, Momentum, and Reversal

Abstract

We propose a rational model to explain time-series momentum. The key ingredient is word-of-mouth communication, which we introduce in a noisy rational expectations framework. Word-of-mouth communication accelerates information revelation through prices and generates momentum. Social interactions allow investors with heterogeneous trading strategies — contrarian and momentum traders — to coexist in the marketplace. As a result, momentum is not completely eliminated, although a significant proportion of investors trade on it. We also show that word-of-mouth communication spreads rumors and generates price run-ups and reversals. Our theoretical predictions are in line with several empirical findings.