We develop a two-state hidden Markov model where the process driving market returns transitions between turbulent and calm states. A cross-sectional momentum strategy embeds a call option on the market, inducing a state-contingent convex relation between market and momentum returns. In turbulent states, the short side of the momentum strategy has high beta and convexity with respect to the market, as a result of higher effective leverage of the past-loser securities, making momentum crashes more likely. A momentum timing strategy based on this model avoids momentum crashes and achieves superior out-of-sample risk-adjusted performance.
Daniel, Kent, Ravi Jagannathan, and Soohun Kim. "A Hidden Markov Model of Momentum." Columbia Business School, February 17, 2019.
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