Detecting Liquidity Needs in the Stock Market Using Equity Analysts' Target Prices

Abstract

We document that liquidity induced deviations between prices and fundamentals can be identified in real time using equity analysts' target price forecasts. The deviations are economically and statistically significant and of a magnitude not easily explained by transaction costs alone. Our benchmark portfolio of S&P500 stocks, for instance, earned an average risk-adjusted return of 195bps per month during the period 1999-2004. We show that the reward required by investors for providing liquidity is highly correlated with standard cross-sectional measures of liquidity such as the bid-ask spread, price impact and changes in trading volume. Finally, our results contribute to the existing literature on analysts' forecasts by pointing out that, while the target price itself need not provide an accurate estimate of true fundamental values, relative valuations of firms within an industry tend to be more precise. This finding is consistent with analysts having skill in analyzing the specifics of individual firms but limited ability to forecast systematic factors driving returns at the sector level.