Market Liquidity as a Sentiment Indicator

48 Pages Posted: 28 Feb 2002 Last revised: 26 Oct 2010

See all articles by Malcolm P. Baker

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)

Multiple version iconThere are 3 versions of this paper

Date Written: February 2002

Abstract

We build a model that helps explain why increases in liquidity - such as lower bid-ask spreads, a lower price impact of trade, or higher share 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, unusually high liquidity is a symptom of the fact that the market is currently 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 (SEOs), 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.

Suggested Citation

Baker, Malcolm P. and Stein, Jeremy C., Market Liquidity as a Sentiment Indicator (February 2002). NBER Working Paper No. w8816. Available at SSRN: https://ssrn.com/abstract=302577

Malcolm P. Baker

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 (Contact Author)

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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