Prior research shows that the residual momentum strategy, which hedges out the time-varying exposures to the Fama–French factors, generates significant and consistent momentum profits. We hypothesize that the profitability of the residual momentum, which is induced by investors’ underreaction to the firm-specific information, is more pronounced when investor sentiment is high. Supporting this notion, we empirically show that the profits to the residual momentum are higher following periods of high investor sentiment. Further investigation indicates that the profitability of the residual momentum persists up to five years and that the persistence exists only following high-sentiment states. We verify the robustness of our results by considering the effects of market states, business cycles, firm size, and different definitions of sentiment states. Overall, our findings provide supportive evidence for the hypothesis of investor underreaction.
