Publication: Cointegration, information transmission, and the lead-lag effect between industry portfolios and the stock market
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2021-02-01
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Wiley
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Abstract
This paper shows that lagged information transmission between industry port-folio 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 oppor-tunity 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.
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Keywords
Cointegration, Equilibrium error, Error correction, Information diffusion, Out-of-sample forecast, Stock return predictability
Bibliographic citation
Troster, V., Penalva, J., Taamouti, A., & Wied, D. (2021). Cointegration, information transmission, and the lead‐lag effect between industry portfolios and the stock market. In Journal of Forecasting, 40 (7), pp. 1291–1309.