Price and earnings momentum: An explanation using return decomposition

• We decompose stock returns into expected return, cash flow news and discount rate news.
• Winners experience higher DR news and thus display lower ex-ante expected returns than losers.
• The persistent CF news drives momentum returns.
• The DR news and especially that from the short leg drives the time-series variations of the profitability of momentum strategies.
• The relative load on past CF news versus DR news can affect long-run portfolio performance.

We explain price and earnings momentum by investigating dynamics of cash flow (CF) news and discount rate (DR) news. We find that before the holding period, winners experience higher DR news than losers, which makes winners display lower ex-ante expected returns than losers. Momentum returns come from the persistently higher CF news for winners as compared to losers both before and during the holding periods. The evidence favors a behavioral explanation that the market incorporates cash flow information too slowly, which drives momentum returns. In addition, we find that the DR news, in particular that of the momentum losers, drives the time-series profitability of momentum strategies. Furthermore, by comparing price momentum with earnings momentum, we show that the relative load on past CF news as compared to past DR news affects long-run portfolio performance.