Productivity, Asset Returns, and International Index Momentum

Abstract

This paper demonstrates that rational momentum can exist in an economy where autocorrelated risk and convex dividend policies are present. It then studies the momentum role of firms. When a firm actively creates positive productivity shocks and accordingly increases its production scale, its output will be convex in productivity. This productivity convexity can generate momentum because a positive productivity shock helps the firm to achieve both higher realized past return and higher expected future return (due to increased exposure to productivity risk). Empirically, productivity-based return components (PBR) on average explain over 50% of the momentum effect in international index returns. This result is robust after adjusting for other risk factors. Macroeconomic variables are also shown to have certain explanatory power for momentum, partially through PBR. Finally, as a robustness check, we find that PBR also explains about 30% of industry momentum in the US.