Comomentum: Inferring Arbitrage Activity from Return Correlations

Abstract

We propose a novel measure of the amount of arbitrage capital allocated to the momentum strategy to test whether arbitrageurs can have a destabilizing effect in the stock market. Our measure, which we dub comomentum, aims to capture the extent to which momentum trades by arbitrageurs become crowded. Specifically, we define comomentum as the high-frequency abnormal return correlation among stocks that a typical momentum strategy would speculate on. We 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 become unprofitable and tend to crash, reflecting prior overreaction due to the momentum crowd pushing prices away from fundamentals. Moreover, both firm-level and international versions of comomentum forecast returns in a manner consistent with our interpretation.

JEL Classification: G12, N22