Abstract

http://ssrn.com/abstract=601881
 
 

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Market Liquidity as a Sentiment Indicator


Malcolm P. Baker


Harvard Business School; National Bureau of Economic Research (NBER)

Jeremy C. Stein


Harvard University - Department of Economics; National Bureau of Economic Research (NBER)


Journal of Financial Markets, Vol. 7, No. 3, pp. 271-299, June 2004

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.

Keywords: Liquidity, Investor Sentiment, Market Timing, Corporate Finance, Behavioral Finance

JEL Classification: G14, G32

Accepted Paper Series


Not Available For Download

Date posted: October 13, 2004 ; Last revised: August 12, 2008

Suggested Citation

Baker, Malcolm P. and Stein, Jeremy C., Market Liquidity as a Sentiment Indicator. Journal of Financial Markets, Vol. 7, No. 3, pp. 271-299, June 2004. Available at SSRN: http://ssrn.com/abstract=601881

Contact Information

Malcolm P. Baker (Contact Author)
Harvard Business School ( email )
Boston, MA 02163
United States
617-495-6566 (Phone)
HOME PAGE: http://www.people.hbs.edu/mbaker
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Jeremy C. Stein
Harvard University - Department of Economics ( email )
Littauer Center
Cambridge, MA 02138
United States
617-496-6455 (Phone)
617-496-7352 (Fax)
HOME PAGE: http://post.economics.harvard.edu/faculty/stein/stein.html
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
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