Excess comovement and stock returns; Evidence from cross-sectional variation in Nikkei 225 weights

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 G10, G14, G15) Several recent papers show that security prices comove in excess of their common fundamentals, casting doubt on the completeness of the model in which comovement is fully explained by common variation in cash flows and discount rates. In their interpretation of the evidence, some authors have argued that excess comovement of stock returns may be explained by the price impact of correlated investor demand, or common liquidity shocks (e.g., Pindyck and Rotemberg, (1993), Lee, Shleifer and Thaler, (1991), Froot and Dabora, (1999)).1 Consistent with the intuition that common variation of stock returns may be explained by commonality in investor demand, there is growing empirical evidence that comovement of security returns is related to the trading patterns of groups of investors. Barberis, Wurgler and Shleifer (2005) find that stocks tend to comove more (less) with index stocks after they are added to (deleted from) the S&P 500 index. They argue that this is consistent with excess comovement being driven by correlated demand by investors who trade index stocks together. Kumar and Lee (2005) show that correlated trades of retail investors are related to patterns of comovement in stock returns. Boyer (2006) argues that correlated tradin