Understanding Comovement
Nicholas Barberis, University of Chicago
Andrei Shleifer, Harvard University
Jeffrey Wurgler, New York University

We consider two broad views of return comovement: the traditional view, derived from frictionless economies with rational investors, which attributes it to comovement in news about fundamental value, and an alternative view, in which market frictions or noise-trader sentiment delink it from comovement in fundamentals. Building on Vijh (1994), we use data on inclusions into the S&P 500 to distinguish these views. After inclusion, a stock’s beta with the S&P goes up. In bivariate regressions which control for the return of non-S&P stocks, the increase in S&P beta is even larger. These results are generally stronger in more recent data. Our findings cannot easily be explained by the fundamentals-based view and provide new evidence in support of the alternative friction- or sentiment-based view.

Many of our members are engaged in risk management activities of one form or another. Invariably, these activities depend on assumptions about how securities move with each other. The results of this study help separate two sources of comovement: fundamental information and market frictions. The former generally cannot be traded upon, unless the comovements are not synchronous. The later may provide valuable trading opportunities to those managers who can characterize the effects of various frictions.