The Value-Momentum Correlation: An Investment Explanation

Abstract

This paper shows that both value and momentum premia arise in a q-theoretic framework that considers optimal corporate policies under uncertain financing conditions. Book-to-market and past performance predict future returns because they serve as indicators of firm financing position. The book-to-market ratio increases with financing constraints, with high book-to-market firms investing less and demanding higher risk premia compared to unconstrained, low book-to-market firms. The value premium increases in bad times because value firms become even more constrained, while ample cash reserves allow growth firms to fare much better. Momentum effects appear among the most financially constrained firms. For these firms, financing constraints imply large price swings following cash-flow shocks and valuable equity market timing options imply positive autocorrelation in returns. Absent equity market timing during bad times, momentum disappears. The model is able to explain many empirical features of value and momentum premia, such as: (i) the procyclicality of the momentum premium, (ii) the countercyclicality of the value premium (iii) the negative correlation between the two, and (iv) severe losses to momentums strategies during market rebounds. Several new testable hypotheses arise regarding the fundamentals of value and momentum stocks. The empirical evidence is largely supportive.

Keywords: momentum, value, investment, debt

JEL Classification: G12, G32, G35