Momentum and Short-Term Reversals: Theory and Evidence
74 Pages Posted: 30 Mar 2022 Last revised: 12 Sep 2022
Date Written: March 29, 2022
How might markets exhibit both short-term reversals and longer-term momentum? Motivated by this question, we develop a dynamic model which includes noise traders and investors who underreact to signals that they do not themselves produce. Our setting implies the following: Return predictability transitions from reversals to weak predictability to momentum as the lag horizon lengthens. Short-term reversals weaken following earnings announcements, and increase when retail trading is higher. These predictions are supported empirically. If noise trader demands are positively autocorrelated, our model generates sharp buildups and collapses of stock prices as in the recent GameStop episode.
Keywords: momentum, reversals, noise traders, liquidity, GameStop
JEL Classification: G02, G12, G14
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