Momentum and Aggregate Default Risk

In this paper, we explain momentum profits using innovations in aggregate economy-wide default risk. First, we show that momentum returns are positive only during high default shocks and nonexistent otherwise. Second, we present evidence suggesting that a conditional default shock factor is priced in the cross-section and can explain a large portion of the total momentum returns. According to our results, winners have potentially higher risk than losers during periods of high default shocks. We confirm this finding in alternate sub-periods where momentum is generally not observed and as well as in international data. We also provide an explanation for this finding by linking momentum profits to potential shareholder recovery during financial distress. We find that winners tend to have relatively higher risk in worsening aggregate default conditions due to lower shareholder bargaining power. These results indicate that momentum profits contain a systematic component related to aggregate default and can be explained in a rational framework