Comomentum: Inferring Arbitrage Activity from Return Correlations

48 Pages Posted: 17 Mar 2012 Last revised: 7 Dec 2012

See all articles by Dong Lou

Dong Lou

London School of Economics & Political Science (LSE); Centre for Economic Policy Research (CEPR)

Christopher Polk

London School of Economics

Date Written: December 6, 2012

Abstract

We propose a novel measure of the amount of arbitrage capital allocated to the momentum strategy to test whether arbitrageurs can have a destabilizing effect in the stock market. Our measure, which we dub comomentum, aims to capture the extent to which momentum trades by arbitrageurs become crowded. Specifically, we define comomentum as the high-frequency abnormal return correlation among stocks that 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 become unprofitable and tend to crash, reflecting prior overreaction due to the momentum crowd pushing prices away from fundamentals. Moreover, both firm-level and international versions of comomentum forecast returns in a manner consistent with our interpretation.

JEL Classification: G12, N22

Suggested Citation

Lou, Dong and Polk, Christopher, Comomentum: Inferring Arbitrage Activity from Return Correlations (December 6, 2012). AFA 2013 San Diego Meetings Paper. Available at SSRN: https://ssrn.com/abstract=2023989 or http://dx.doi.org/10.2139/ssrn.2023989

Dong Lou (Contact Author)

London School of Economics & Political Science (LSE) ( email )

Department of Finance
Houghton Street
London, WC2A 2AE
United Kingdom
+44 (0)207 1075360 (Phone)

HOME PAGE: http://personal.lse.ac.uk/loud/

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Christopher Polk

London School of Economics ( email )

United Kingdom

HOME PAGE: http://personal.lse.ac.uk/polk/

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