Liquidity Shocks and Stock Market Reactions
108 Pages Posted: 10 May 2012 Last revised: 26 Aug 2013
Date Written: August 23, 2013
We find that the stock market underreacts to stock level liquidity shocks: liquidity shocks are not only positively associated with contemporaneous returns, but they also predict future return continuations for up to six months. Long-short portfolios sorted on liquidity shocks generate significant returns of 0.70% to 1.20% per month that are robust across alternative shock measures and after controlling for risk factors and stock characteristics. Furthermore, we show that investor inattention and illiquidity contribute to the underreaction: while both are significant in explaining short-term return predictability of liquidity shocks, the inattention-based mechanism is more powerful for the longer-term return predictability.
Keywords: Stock returns, liquidity shocks, stock market reactions, underreaction, investor attention
JEL Classification: G02, G10, G11, G12, G14, C13
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