Cointegration, information transmission, and the lead‐lag effect between industry portfolios and the stock market

Abstract

This paper shows that lagged information transmission between industry portfolio and market prices entails cointegration. We analyze monthly industry portfolios in the US market for the period 1963-2015. We find cointegration between six industry portfolio and market prices. We show that the equilibrium error, the long-term common factor between industry portfolio and market cumulative returns, has strong predictive power for excess industry portfolio returns. In line with gradual information diffusion across connected industries, the equilibrium error proxies for changes in the investment opportunity set that lead to industry return predictability by informed investors. Forecasting models including the equilibrium error have superior forecasting performance relative to models without it, illustrating the importance of cointegration between the industry portfolio and market prices. Overall, our findings have important implications for investment and risk-management decisions, since the out-of-sample explanatory power of the equilibrium error is economically meaningful for making optimal portfolio allocations.

Dynamic Correlation between the Chinese and the US Financial Markets: From Global Financial Crisis to COVID-19 Pandemic

“…Nevertheless, the financial shocks lag with the actual side of the economy because of the information transmission. As Troster et al [62] point out in their study, industry information has a predictive effect on the financial returns in the stock market. The observations during the COVID-19 period show that the lags between SCHI and the US indexes exhibit a reverse relationship compared to the previous periods as the yield volatility in China matches the same day US indexes, indicating an increasing impact power of China during the pandemic and a mimic effect of the US stock market to China's one.…”

Industry return lead-lag relationships between the US and other major countries

“…Most notably, Kanas and Kouretas ( 2005 ) showed an improvement in the forecasting ability of cointegration between the lagged price of large-firm portfolios and the current price of small-firm portfolios in the UK equity market. Troster et al ( 2021 ) found that the long-term common factor (equilibrium error) between industry portfolios and market cumulative returns has strong predictive power for monthly excess industry portfolio returns in the US. Hence, considering long-run relationships may improve the forecasting ability of international industry returns.…”