Time-series and cross-sectional excess comovement in stock indexes

This paper is an empirical investigation of the excess comovement among 82 industry indexes in the U.S. stock market between January 5, 1976 and December 31, 2001. We define excess comovement as the covariation between two assets beyond what can be explained by fundamental factors. In our analysis, the fundamental factors are sector groupings and the three Fama-French factors. We then estimate residuals of joint (FGLS) rolling regressions of these fundamentals on industry returns. Finally, we compute excess comovement as the mean of square unconditional, statistically significant correlations of these residuals. We show that excess comovement is high (about 0.07, i.e., equivalent to an average absolute correlation of 0.26), statistically significant, and represents an economically significant portion (almost 30%) of the average gross square return correlation. Excess comovement is also uniformly significant across industries and over time and only weakly asymmetric, i.e., not significantly different in rising or falling markets. We explain more than 23% of this market-wide (and up to 73% of sector-wide) excess square correlation by its positive relation to proxies for information heterogeneity and U.S. monetary and real conditions, and its negative relation to market volatility and the level of the short-term interest rate. This evidence is consistent with the implications of portfolio rebalancing and product market theories of financial contagion, but offers little or no support for the correlated liquidity shock channel.