Liquidity Shocks and Stock Market Reactions

Turan G. Bali, Lin Peng, Yannan Shen and Yi Tang

The Review of Financial Studies, 2014, vol. 27, issue 5, 1434-1485

Abstract: 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.

Date: 2014
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