Cycles of Declines and Reversals following Overnight Market Declines
40 Pages Posted: 2 Dec 2018 Last revised: 8 Feb 2019
Date Written: September 2018
This paper uncovers and explains the emergence of cycles of intraday declines and overnight reversals in the U.S. stock market in the 21st century. Using quote midpoints for the past 24 years of common stocks traded in the three main exchanges, I show that the cross-sectional association between average intraday and overnight returns has steadily shifted from a direct association into a strong inverse association over the years. I explain this shift by showing that after 2001, consistent with theoretical models in which binding capital constraints lead to liquidity dry-ups, an overnight decline in the stock market is followed by a further intraday decline for volatile stocks and their reversal over the next overnight period. Moreover, I show that market liquidity of volatile stocks further deteriorates following an overnight market decline, which confirms my proposed explanation. Finally, I show that idiosyncratic volatility, compared with systematic risk, better explains the cross section of the documented systematic intraday declines and overnight reversals.
Keywords: Market Liquidity, Funding Liquidity, Reversals, Effective Spread, TAQ
JEL Classification: G10, G12, G15, G20
Suggested Citation: Suggested Citation