Where Does the Predictability from Sorting on Returns of Economically Linked Firms Come From?

Aaron Burt and Christopher Hrdlicka

Cross-firm predictability among economically linked firms can arise when both firms exhibit own-momentum and their returns are contemporaneously correlated. We show that cross- firm predictability can last up to 10 years, which is hard to reconcile with an interpretation of slow information diffusion. However, it is consistent with the economically linked firms’ commonality in momentum. The contribution of each source can be found by decomposing leaders’ returns into the predictable (momentum) and news components. Sorting on each, we find that both sources contribute almost equally to 1-month predictability, while commonality in momentum is solely responsible for longer-horizon cross-firm predictability.