Stock Liquidity and the Earnings-Return Asymmetry for Negative versus Positive Returns
53 Pages Posted: 2 Dec 2018
Date Written: October 1, 2018
Prior research finds that the association between earnings and contemporaneous returns is larger for negative returns than for positive returns. This earnings-return asymmetry is often attributed to conditional conservatism (i.e., accounting rules adopt a higher accounting verification threshold for recognizing good news as gains than for recognizing bad news as losses). We argue that this asymmetry may also be driven by the lack of timeliness with which stock prices incorporate bad news. If this is the case, the earnings-return asymmetry will be weaker for firms with more liquid stocks because their stock prices reflect bad news more timely. In support of our argument, we find that the asymmetry becomes weaker (and even disappears) as stock liquidity increases. This suggests that for firms with illiquid stocks, the earnings-return asymmetry can exist without conditional conservatism. Using reductions in the minimum tick size as plausibly exogenous shocks to stock liquidity, we show that the effect of stock liquidity on the asymmetry is likely causal. Our findings support the conjecture in Dechow, Ge, and Schrand (2010) that variation in the earnings-return asymmetry may also reflect variation in the quality of the return generation process rather than conditional conservatism.
Keywords: Conditional conservatism, Stock liquidity, Earnings-return asymmetry, Asymmetric timeliness
JEL Classification: G14, G40, M40, M41
Suggested Citation: Suggested Citation