Distinguishing Rational and Behavioral Models of Momentum

One of the many challenges facing financial economists is to distinguish the theories explaining momentum. Brav and Heaton (2002) show that it is very difficult to distinguish the “rational” models of structural uncertainty (SU) from “behavioral” models of conservatism (C). In this paper, I reexamine the SU model and the C model proposed by Brav & Heaton (2002) in explaining short run momentum. Based on simulated data, I find that they differ from each other in the relation between agent’s earnings forecast revision and the lagged earnings change. This relation is significantly negative for the SU model and significantly positive for the C model. Empirical evidence provides support for the SU model. ∗I thank Andrew Metrick, Jessica Wachter, and Yihong Xia, for encouragement and many helpful discussions. Special thanks are given to Andrew Metrick for editorial help. I also thank Robert Stambaugh, Geoffrey Tate, Amir Yaron and Motohiro Yogo for helpful comments. All errors are mine.