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Time-Varying Momentum Payoffs and Illiquidity

This paper shows that the profitability of the momentum trading strategy strongly varies with the state of market illiquidity, consistent with behavioral models of investor’s expectations. Periods of high market illiquidity are often followed by low, and often massively negative, momentum payoffs. The predictive power of market illiquidity uniformly exceeds that of competing state variables, including market states, market volatility, and investor sentiment, and is robust in both inand out-of-sample experiments as well as among large cap firms. Market illiquidity also captures the cross-sectional dispersion in momentum payoffs implemented among high versus low volatility stocks. Focusing on the most recent decade, while momentum profitability is nonexistent unconditionally, it regains significance in periods of low market illiquidity, and moreover, market illiquidity similarly affects the profitability of the earnings momentum trading strategy.