“Market Confidence and Momentum” by Jianguo Xu
University of Toronto
We develop a model in which equity fundamentals are subject to random shocks. Investors learn about the shocks through noisy information. The model shows that momentum is more pronounced in a more confident market. We conduct tests of the prediction and find supportive evidence. Specifically, we find that market volatility negatively predicts momentum profits. This evidence supports the prediction since a more volatile market is likely to be less confident. The model also predicts that idiosyncratic shocks, not systematic shocks, produce momentum. This is consistent with empirical findings from a number of studies.