Market Liquidity as a Sentiment Indicator

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.