The Information Role of Liquidity Shock, Firm Fundamentals, and Long-Term Stock Value

Abstract

This paper focuses on explaining the effect of liquidity shocks on asset prices. This is the first paper that finds that negative liquidity shocks lead to lower stock prices in the short run; yet the initial underperformance only lasts for short period and is reversed in the longer time horizon. We explain the short-term price drop and long run price appreciation by changes in firm level fundamentals and information uncertainty. Specifically, stocks of negative liquidity shocks exhibit worsening firm level fundamentals and higher level of information uncertainty in the following several quarters after the initial liquidity shock. As time horizon is expanded, both firm level fundamentals and information uncertainty show signs of improvement. The unanticipated changes in fundamentals and information uncertainty explain the initial underperformance and subsequent outperformance.