Where Does the Predictability from Sorting on Returns of Economically Linked Firms Come From?
Forthcoming, Journal of Financial and Quantitative Analysis
39 Pages Posted: 12 Apr 2014 Last revised: 26 Feb 2020
Date Written: January 31, 2020
Cross-firm predictability among economically linked firms can arise when both firms exhibit own-momentum and their returns are contemporaneously correlated. We show that cross-firm predictability can last up to 10 years, which is hard to reconcile with an interpretation of slow information diffusion. However, it is consistent with the economically linked firms' commonality in momentum. The contribution of each source can be found by decomposing leaders' returns into the predictable (momentum) and news components. Sorting on each, we find that both sources contribute almost equally to 1-month predictability, while commonality in momentum is solely responsible for longer-horizon cross-firm predictability.
Keywords: model missspecification, price discovery, economic links, return predictability, information diffusion, market efficiency, investor inattention, limits to arbitrage, lead-lag effect, networks
JEL Classification: G10, G12, G14
Suggested Citation: Suggested Citation