Market liquidity as a sentiment indicator [An article from: Journal of Financial Markets]

by M. Baker, J.C. Stein

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This digital document is a journal article from Journal of Financial Markets, published by Elsevier in 2004. The article is delivered in HTML format and is available in your Amazon.com Media Library immediately after purchase. You can view it with any web browser.

Description:
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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