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

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) model, this paper documents: (i) significant relationship between market liquidity and sentiment, (ii) market liquidity negatively predicts subsequent market returns, (iii) market liquidity based explanation to the underreaction to liquidity shocks and idiosyncratic liquidity. Markets dominated by irrational investors contribute significantly to the underreaction. Hence, a long-short liquidity shocks (idiosyncratic liquidity) strategy earns significantly higher (lower) returns during abnormally liquid (illiquid) market states