Stock Liquidity and the Earnings-Return Asymmetry for Negative versus Positive Returns

Abstract

The larger association between earnings and contemporaneous returns for negative returns than for positive returns is often attributed to conditional conservatism. We reason that this asymmetry may also be driven by the lack of timeliness with which stock price incorporates bad news relative to good news. Consistent with our reasoning, we show that when stock price incorporates bad news with delay, the asymmetry can exist in the absence of conditional conservatism. This suggests the testable hypothesis that the asymmetry decreases (increases) with factors that facilitate (impede) the incorporation of bad news into stock price. Using stock liquidity to test this hypothesis, we find that the earnings-return asymmetry decreases, and even disappears, as stock liquidity increases. Our findings support the view that variation in the earnings-return asymmetry may also reflect variation in the quality of the return generating process.