Short Term Reversals, Returns to Liquidity Provision and the Costs of Immediacy

Abstract

In this paper, we study short-term return reversals using a sample of all but the smallest of NYSE and Amex stocks. We perform for each day a cross-sectional regression, where we regress the stocks’ next 5-days’ abnormal returns on each of their past five days’ abnormal returns. Our daily measure of liquidity is the sum of the coefficients from this regression. We show that 1) changes in quarterly averages of liquidity explain 10% of the quarterly changes in the average turnover in the US stock market and 2) changes in quarterly averages of liquidity explain 12% of the quarterly returns to CRSP equallyweighted market index. We then look at the returns to providing liquidity, i.e., the returns to a trading strategy that buys stocks in the decile (quartile) with the highest expected weekly returns, evaluated using historical estimates of mean reversion, and sells stocks in the decile (quartile) with the lowest expected returns. During our sample period, 1926-2008, this strategy has generated on average 0.3% (0.2%) daily returns. These returns have been declining over time and were only 0.07% (0.05%) during the last decade. The market makers’ returns to providing liquidity equal the costs of immediacy to other investors. Using the daily returns to liquidity provision as a measure of the costs of immediacy, we find that mutual funds have on average lost 3.0% per year during the last decade to trading costs that arise from the price pressure from requiring immediacy. Without these costs, according to our results, the average mutual fund would have generated returns roughly equal to those of the value-weighted CRSP index.