Market liquidity as a sentiment indicator |
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| Affiliation: | 1. Harvard Business School, Harvard University, Boston, MA 02163, USA;2. Harvard Economics Department, Harvard University, Cambridge, MA 02138, USA;3. National Bureau of Economic Research, Cambridge, MA 02138, USA;1. School of Economics and Management, Southwest Jiaotong University, Chengdu, Sichuan Province, 610031, PR China;2. Civil Aviation Flight University of China, Guanghan, Sichuan Province, 618307, PR China;3. Oklahoma State University, Stillwater, Oklahoma, USA;1. Financial Stability Department, Czech National Bank, Na Příkopě 28, 115 03, Prague, Czech Republic;2. Department of Finance, Masaryk University, Lipová 41a, 602 00, Brno, Czech Republic;1. Kelley School of Business, Indiana University, United States;2. Krannert School of Management, Purdue University, United States;3. Jones School of Business School, Rice University, United States;4. China Academy of Finance Research, Shanghai Advanced Institute of Finance, China;1. Department of Finance, NUS Business School, National University of Singapore, 15 Kent Ridge Drive, 119245, Singapore;2. Bunge Agribusiness Singapore Private Limited, 77 Robinson Road, 068896, Singapore |
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| Abstract: | We build a model that helps to explain why increases in liquidity—such as lower bid–ask spreads, a lower price impact of trade, or higher turnover–predict lower subsequent returns in both firm-level and aggregate data. The model features a class of irrational investors, who underreact to the information contained in order flow, thereby boosting liquidity. In the presence of short-sales constraints, high liquidity is a symptom of the fact that the market is dominated by these irrational investors, and hence is overvalued. This theory can also explain how managers might successfully time the market for seasoned equity offerings, by simply following a rule of thumb that involves issuing when the SEO market is particularly liquid. Empirically, we find that: (i) aggregate measures of equity issuance and share turnover are highly correlated; yet (ii) in a multiple regression, both have incremental predictive power for future equal-weighted market returns. |
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