Inferring Arbitrage Activity from Return Correlations

We propose a novel measure of arbitrage activity to examine whether arbitrageurs can have a destabilizing e¤ect in the stock market. We apply our insight to stock price mo- mentum, a classic example of an unanchored strategy that exhibits positive feedback since arbitrageurs buy stocks when prices rise and sell when prices fall. We de?ne our measure, which we dub comomentum, as the high-frequency abnormal return correlation among stocks on which a typical momentum strategy would speculate. We show that during periods of low comomentum, momentum strategies are pro?table and stabilizing, re?ecting an underreac- tion phenomenon that arbitrageurs correct. In contrast, during periods of high comomentum, these strategies tend to crash and revert, re?ecting prior overreaction resulting from crowded momentum trading pushing prices away from fundamentals. Theory suggests that we should not ?nd destabilizing arbitrage activity in anchored strategies. Indeed, we ?nd that a cor- responding measure of arbitrage activity for the value strategy, covalue, positively forecasts future value strategy returns, and is positively correlated with the value spread, a natural anchor for the value-minus-growth trade. Additional tests at the ?rm, fund, and interna- tional level con?rm that our approach to measuring arbitrage activity in the momentum strategy is sensible. JEL classi?cation: G02, G12, G23