Excess Comovement and a Transient Factor in Stock Returns

Abstract

We investigate sources and implications of excess comovement in stock returns. Using an asset pricing model under asymmetric information we show that (1) commonality in noise trading across assets introduces a transient (common) factor in asset returns that is responsible for their comovement in excess of correlation generated by a common component in their fundamental values, and (2) there is a close tie between excess comovement and negative cross-autocorrelations, and only a model with both fundamental and transient return factors can generate positive and negative signs for return cross-autocorrelations. Empirically, we show that negative signs are frequently observed in the cross-autocorrelations of daily returns on a broad range of stock portfolios, which supports the presence of a transient common factor in stock returns. We use cross-autocovariance moment conditions to estimate an extended version of our model, and recover permanent and transient return factors. Our two-factor model fits daily portfolio returns very well, and the transient factor significantly helps in explaining the dynamics of short term returns. We provide evidence that infrequent trading does not significantly influence our results. We estimate “information frictions” (delays in price response to factor shocks) and show that the fundamental friction is decreasing, while transient friction is increasing, in firm size. For the fundamental friction, we find an annual premium in the range of 1.7% to 4.1%. Within the subset of small firms, fundamental and transient friction premia are more pronounced and statistically significant.