Excess Comovement of Stock Returns: Evidence from Cross-Sectional Variation in Nikkei 225 Weights

Abstract

Relative to their weights in a value-weighted index, a number of stocks in Japan's Nikkei 225 stock index are overweighted by a factor of 10 or more. I document a strong positive relation between overweighting and the comovement of a stock with other stocks in the Nikkei index, and a negative relationship between index overweighting and comovement with stocks outside of the index. The cross-sectional approach resolves endogeneity problems associated with event study demonstrations of excess comovement. A trading strategy that bets on the reversion of stock prices of overweighted stocks generates economic profits, confirming that the observed comovement patterns are excessive, and providing further evidence that comovement of stock returns can be a consequence of commonality in trading behavior.

JEL Classification: G10, G14, G15