Comomentum:  Inferring Arbitrage Activity from Return Correlations
Dong Lou, London School of Economics
Christopher Polk, London School of Economics

The authors propose a novel measure of arbitrage activity to examine whether arbitrageurs can have a destabilizing effect in the stock market. They apply their insight to stock price momentum, a classic example of an unanchored strategy that exhibits positive feedback since arbitrageurs buy stocks when prices rise and sell when prices fall. Their measure, which they call comomentum, is the high-frequency abnormal return correlation among stocks on which a typical momentum strategy would speculate. They 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 crowded momentum trading pushing prices away from fundamentals. Theory suggests that we should not find destabilizing arbitrage activity in anchored strategies. The authors find that a corresponding measure of arbitrage activity for the value strategy, covalue, positively forecasts future value strategy returns, and is 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 this approach to measuring arbitrage activity in the momentum strategy is sensible.

Momentum and overreaction characterize many assets, but they both can’t simultaneously be useful to investment managers. Knowing the relation between the two phenomena and which phenomenon will characterize the near future is of obvious importance to managers who consider momentum and overreaction when making portfolio decisions.