Vol. 4 No. 2 | Fall 2002


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The Pack Mentality

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 funds.

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 are traded.

"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 fails.

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.

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