Predictable asset price dynamics, risk-return tradeoff, and investor behavior

Using a testable Slutsky equation derived from a formal utility maximization model of portfolio choice under uncertainty, we examine whether the momentum component in daily returns is induced by the interaction of the intertemporal risk-return tradeoff and investor tendency to correct prior mispricing. We find that a substantial portion of short-horizon momentum is generated by the asymmetric intertemporal risk-return tradeoff that the positive risk-return relation is strengthened conditional on a prior negative market return but is attenuated conditional on a prior positive market return. With the observation of a highly positive correlation between the trading signals and price change dummies, we further explore the link between technical trading profits and the two pricing factors. Our empirical results provide strong evidence that the profits associated with technical strategies come from exploiting the same momentum component induced by the interaction of the risk-return relation and investor adjustment behavior. We conclude that technical trading profits are the result of rational pricing factors and therefore not evidence of market inefficiency.