Expected Market Returns and Underreaction to Liquidity: A Market Liquidity (Sentiment) Based Explanation

Abstract

While investors demand a premium to hold stocks with high illiquidity level and risk, they underreact to stock-level liquidity shocks and idiosyncratic liquidity. Built on Baker and Stein (2004) market liquidity model, this paper: (i) reports a significant relationship between market liquidity and investor sentiment, (ii) shows that market liquidity (illiquidity) negatively (positively) predicts subsequent market returns, (iii) provides market liquidity based explanation to the underreaction to liquidity shocks and idiosyncratic liquidity. Markets dominated by irrational sentiment-driven investors contribute significantly to the underreaction to liquidity shocks and idiosyncratic liquidity. As a result, a long-short liquidity shocks (idiosyncratic liquidity) strategy earns significantly high returns during abnormally liquid market states. On the other hand, the cross-sectional relationships between the liquidity measures and future stock returns weaken moving from abnormally liquid (positive sentiment) to illiquid (negative sentiment) market states.

Keywords: Market liquidity, sentiment, liquidity shocks, idiosyncratic liquidity, underreaction, cross-section of returns.

JEL Classification: G11, G12, G41