Market Structure and Effect of Sentiment on Liquidity

Abstract

This paper examines how market structure influences the channel through which investor sentiment affects liquidity. Theory predicts that higher irrational investor sentiment is associated with lower illiquidity but through different channels. Thus, market structure has implications for return continuation, a result of underreaction to information. In a market with a specialist market maker, there is no underreaction to information in the orderflow and hence return continuation is not affected by investor sentiment. However, in a market without a specialist market maker, irrational traders underreact to the information in the order flow and hence higher investor sentiment is associated with higher return continuation. The empirical evidence supports these predictions. For both NYSE as well as Nasdaq, illiquidity is lower in the periods of high investor sentiment. Return continuation for Nasdaq, but not for NYSE, is higher in periods of high sentiment.