A Behavioral Finance View of Stock Price Comovement Research by Nicholas Barberis
By looking carefully at data on individual stock prices, it
is easy to find many examples of "comovement"-groups
of stocks whose prices tend to move together. For instance,
prices of stocks in the same industry tend to move together,
as do the prices of small-cap stocks, value stocks, and closed-end
The traditional way of understanding comovement in stock prices
is the so-called "fundamentals-based" approach. This
approach says that stock prices move together because the intrinsic
values of the underlying firms move together. Intrinsic value
represents the true value of a firm, and is usually measured
by taking the firm's future earnings and discounting them at
a rate appropriate for their risk. The fundamentals-based view
is a direct implication of the Efficient Markets Hypothesis
(EMH), a popular way of thinking about financial markets, which
argues that stock prices always equal intrinsic value.
"If you believe the EMH, you also have to believe that
comovement in prices is due to comovement in intrinsic values,"
says Nicholas Barberis, an associate professor at the University
of Chicago Graduate School of Business.
There is little doubt that the fundamentals-based view of comovement
does explain many examples of stock prices moving in tandem.
For example, the reason the prices of oil industry stocks tend
to move together is that their earnings and hence also their
intrinsic values are related: when one oil company reports good
bottom-line results, it is rather likely that others will too.
In their recent paper, "Comovement," Barberis, Andrei
Shleifer of Harvard University, and Jeffrey Wurgler of New York
University's Stern School of Business argue that the fundamentals-based
view, while useful, doesn't capture many interesting examples
of comovement in the data.
Puzzling Examples of Comovement
There are a number of interesting stock market patterns that
don't fit neatly into the traditional view. One example concerns
so-called "twin stocks," which are stocks that are
claims to the same cash-flow stream, but are primarily traded
in different locations. The best-known example is Royal Dutch
and Shell. Royal Dutch and Shell used to be completely independent
companies, but in 1907 they agreed to merge their interests
while remaining separate entities.
Today, shares of Royal Dutch are traded primarily in the United
States and in the Netherlands, and are a claim to 60 percent
of the combined firm's cash flow, while Shell shares, traded
primarily in the United Kingdom, are a claim to the remaining
40 percent. Since the two shares are claims to exactly the same
cash-flow stream, the fundamentals-based view of comovement
argues that the prices of the two shares should move in lock-step
with one another. In reality, the two stocks seem to have minds
of their own-Royal Dutch moves closely with the S&P index,
while Shell's movements are closely tied to those of the FTSE
index of U.K. stocks.
A related example concerns closed-end country funds, whose
assets are traded in a different location from the funds themselves.
For example, there are closed-end funds invested entirely in
German equities, but whose shares trade primarily in New York.
Since a closed-end fund and the assets it holds are claims to
very similar cash-flow streams, the price of the closed-end
fund and the value of its holdings should move together very
closely. However, this is not often the case. Closed-end country
funds tend to move more closely with the national market where
they are traded than with the national market where their holdings
"In our example, a Germany fund would tend to move more
closely with the U.S. market even though all its holdings are
German equities," says Barberis.
Finally, there is strong evidence that small-cap stocks tend
to move together, as do value stocks. The fundamentals-based
view would suggest that the earnings of small-capitalization
firms, or of value firms, move in tandem. While this explanation
may sound plausible, it has not been confirmed-times of good
and bad returns on small-cap stocks do not match up well with
times of good and bad earnings on these stocks.
A New View
Barberis, Shleifer, and Wurgler propose an alternative view
of stock price comovement, which they call "category-based"
comovement. Their approach can be generally classified as a
behavioral finance view of comovement, in reference to the growing
field of finance arguing that there are many instances where
prices deviate from intrinsic value, and hence where the EMH
The category-based view starts from the observation that many
investors like to allocate funds at the level of asset categories,
rather than at the level of individual securities. These investors
tend to group stocks into broad classes-small-cap, medium-cap,
large-cap, value, growth, domestic, international-and then move
funds between these classes. Such an approach can simplify the
investment process-it is much easier to decide between ten categories
than between thousands of listed stocks. This approach may appeal
particularly to institutional investors who are expected to
follow a systematic framework in their decision making. Category-based
investing provides such a framework.
The authors argue that these categories may also become adopted
by irrational investors, sometimes known as "noise traders,"
whose decisions are guided more by sentiment than by rational
decision making. As these noise traders shift funds between
categories, they may induce comovement that has nothing to do
with intrinsic values. For example, if noise traders become
irrationally enthusiastic about growth stocks and channel funds
into that category, the common buying pressure will make the
prices of growth stocks move together even if the earnings of
growth stocks have little to do with one another.
An S&P-based Test
To provide a definitive test of the category-based view, the
authors turned to data on stock inclusions into the S&P
500 stock index. Stocks are often removed from this index because
of mergers or bankruptcy, and new stocks are added. Under the
fundamentals view, after a stock is added, there should be no
change in the way it comoves with the other stocks already in
the S&P. Standard and Poors explicitly state that they are
not trying to provide any information about intrinsic value
when they add a stock to their index. They are simply trying
to create an index that is representative of the U.S. economy
as a whole. If the intrinsic value of a stock doesn't change
when it is added to the index, the way it comoves with other
S&P 500 stocks should also remain unaffected.
The category-based view, however, predicts something quite
different. It argues that the S&P is a very popular category
for many investors, and that some of these investors may be
noise traders. If so, a stock that is added to the S&P index
will start to be buffeted by these index-level noise trader
fund flows, making the stock move more closely with other S&P
stocks than it did before. This effect should also be stronger
in more recent data, in line with the growing popularity of
the S&P as a category.
In their calculations, Barberis, Shleifer, and Wurgler found
evidence that confirmed their predictions. When stocks are added
to the S&P index, they immediately start moving more in
line with other S&P stocks, and less in line with non-S&P
stocks. Moreover, the effect seems to be somewhat stronger in
the 1990s than in the 1980s.
Barberis, Shleifer, and Wurgler argue that the category view
of comovement may be helpful in understanding instances of comovement
beyond the S&P example. This view can be applied to the
puzzling case of value stocks, which have returns that don't
seem to match up well with their earnings. Value stocks also
are increasingly being thought of as a category. If noise traders
channel funds in and out of this category, value stocks may
begin to move together for reasons unrelated to intrinsic value,
as the evidence appears to suggest.
In the case of Royal Dutch and Shell, Royal Dutch is a member
of the S&P, while Shell is a member of the FTSE index.
"If we think of Royal Dutch and Shell as being buffeted
by the flows of noise traders in and out of the two indices,
it becomes less surprising that they don't move perfectly in
tandem," says Barberis.
More generally, the category-based view suggests that there
is excess comovement in stock prices, with stocks in the same
category moving together more than their intrinsic values say
that they should. In the past two years, investors have rushed
out of the tech-stock category, apparently disillusioned with
its prospects. In most cases, this pessimism may be justified.
On the other hand, in allocating funds at the category level,
investors may also be withdrawing capital from perfectly viable
tech-stock companies, who are now having to cancel potentially
profitable projects simply because they have been lumped in
with the mass of other less attractive firms.
However, the authors caution that the advantages of the category-based
view should not be overstated. In the case of the S&P, part
of the common movement of S&P stocks results from the strategies
of S&P options and futures traders. Since there are fewer
derivative-based products linked to categories such as small-cap
or value stocks, category-based comovement may be less important
in these cases.
Nicholas Barberis is associate professor of finance at the
University of Chicago Graduate School of Business.