The Making of Momentum A Demand-System Perspective

Abstract

I develop a framework to quantify which features of investors’ trading strategies lead to momentum in equilibrium. Specifically, I distinguish two channels: persistent demand shocks, capturing underreaction, and the term structure of demand elasticities, representing an intensity of arbitrage activity that decreases with investor horizon. I introduce both aspects of dynamic trading into an asset demand system and discipline the model using the joint behavior of portfolio holdings and prices. I estimate the demand of institutional investors in the U.S. stock market between 1999 and 2020. On average, investors respond more to short-term than longer-term price changes: the term structure of elasticities is downward-sloping. My estimates suggest that this channel is the primary driver of momentum returns. Moreover, in the cross-section, stocks with more investors with downward-sloping term structures of elasticities exhibit stronger momentum returns by 7% per year.