Comomentum: inferring arbitrage activity from return correlations

Dong Lou and Christopher Polk

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: We propose a novel measure of arbitrage activity to examine whether arbitrageurs can have a destabilizing effect in the stock market. We apply our insight to stock price momentum, a classic example of an unanchored strategy that exhibits positive feedback as arbitrageurs buy stocks when prices rise and sell when prices fall. We define our measure, which we dub comomentum, as the high-frequency abnormal return correlation among stocks on which a typical momentum strategy would speculate on. We show that during periods of low comomentum, momentum strategies are profitable and stabilizing, reflecting an underreaction phenomenon that arbitrageurs correct. In contrast, during periods of high comomentum, these strategies tend to crash and revert, reflecting prior overreaction resulting from the momentum crowd pushing prices away from fundamentals. Theory suggests that we should not find destabilizing arbitrage activity in anchored strategies. Indeed, we find that a corresponding measure for the value strategy, covalue, indicates that arbitrage activity in that strategy is always stabilizing and, in fact, positively correlated with the value spread, a natural anchor for the value-minus-growth trade. Additional tests at the firm, fund, and international level confirm that our approach to measuring arbitrage capital in the momentum strategy is sensible.

JEL-codes: G12 N22 (search for similar items in EconPapers)
Pages: 50 pages
Date: 2013-04-01
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http://eprints.lse.ac.uk/119033/ Open access version. (application/pdf)

Related works:
Journal Article: Comomentum: Inferring Arbitrage Activity from Return Correlations (2022)
Working Paper: Comomentum: inferring arbitrage activity from return correlations (2022)
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Persistent link: https://EconPapers.repec.org/RePEc:ehl:lserod:119033

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