Stock Return Comovement in the New Millennium

Abstract

Long run dynamics in stock return comovement, their causes and consequences, are hotly debated topics in Financial Economics. Average return correlation, or comovement, is a widely used market efficiency indicator. I study the times series characteristics in US comovement during the 1926- 2010 period and find a significant break in the series’ trend in January of 1997. After the break, the negative comovement trend previously documented for most of the 20th century reverts to strongly positive. In addition, I find a decline in the importance of firm-specific volatility after the break and no evidence of a trend reversal in the correlation structure of firm cash flows. This suggests that higher return comovement is the result of correlated trading unrelated to firm fundamentals. I discuss several potential explanations for this increase, cause by technological change in the financial sector.

Keywords: stock return comovement; stock correlations; systematic volatility, idiosyncratic volatility; structural break

JEL Classification: G14, G15, C22