Investor Sentiment and Stock Market Liquidity

Abstract

Recent research on liquidity has reported that the aggregate liquidity in the stock market varies over time and there is evidence suggesting that this variation affects stock returns. Although the importance of market liquidity in asset pricing has been well documented, we know little about what causes stock market liquidity to vary over time. This paper examines how investor sentiment affects the time-series variation in stock market liquidity. I use the measure developed by Amihud (2002) as a proxy for liquidity. The investor sentiment measures consist of two types: direct and indirect measures. The direct measures are constructed from the Index of Investor Intelligence (as a proxy for institutional investor sentiment) and the Index of the American Association of Individual Investors (as a proxy for individual investor sentiment). The indirect measure is the Baker and Wurgler (2005) sentiment index (BW index). The results show that the stock market is more liquid when investor sentiment is higher. Specifically, both institutional investor sentiment and individual investor sentiment have significant positive effects on market liquidity. The BW index is also associated with higher market liquidity but the effect is much weaker. Further tests show that the BW index only influences the liquidity of a subset of stocks. Overall, the results are consistent with the theoretical prediction that investor sentiment increases stock market liquidity.