How Much of Cross-Stock Momentum Reflects Underreaction? 

Abstract

Many studies find that returns of related stocks cross-predict each other ("cross-stock momentum"). These patterns have been interpreted as underreaction to cash flow information, which implies that the returns should persist. However, we document that they revert over the long run. To further understand cross-stock momentum, we show that a significant component of these returns reflect common momentum in factor portfolios, which fully accounts for the reversal. After removing these effects, the resulting return predictability appears more consistent with underreaction: it represents uni-directional lead-lags, and the returns mainly manifest in small and hard-to-arbitrage stocks. On a dollar-weighted basis, only a small portion of cross-stock momentum appears consistent with underreaction.

Keywords: Lead-Lag, Cross-Stock Momentum, Factor Momentum, Underreaction, Inattention

JEL Classification: G11, G12, G14, L14