The Pulse

Liquidity: Like Anything Else, Confidence Helps

Can a few ‘irrationally overconfident investors’ game the market?

by Timothy Bernstein, Analyst

Mr. Bernstein is affiliated with New Oak, a financial advisory and consulting firm providing clients with strategic insight, transparency and risk management. Reprinted with permission. Visit

Last Tuesday, right between the equity market’s morning rally and afternoon freefall, one economic indicator actually provided some good news. The Conference Board’s Consumer Confidence Index rose in August to 101.5, the second-highest reading since the financial crisis (January 2015 was the highest) and a nine-point improvement over July’s number.

An ever-growing body of research has demonstrated the correlations between consumer and investor sentiment and equity prices, spending, inflation, or GDP growth. The relationship between the level of confidence and stock market liquidity, on the other hand, requires a little more digging. The results, however, point to a strong link between the two in which the causality lies with confidence, both for consumers and investors.

Sending ‘sentiment shocks’

Consider the 2004 study from two Harvard economics professors that found stock market liquidity to be a strong indicator of investor confidence. The resulting paper, co-authored by Malcolm Baker and Jeremy C. Stein, theorized a group of “irrationally overconfident investors” that believe themselves to be more precise readers of the market than everyone else. These investors, according to Baker and Stein’s hypothesis, cause “sentiment shocks” in the market that increase trading volume, while also under-reacting to the trading decisions of other (allegedly less well-informed) investors, which lowers the price impact of trades and increases liquidity.[1]

Baker and Stein’s chief contribution is to demonstrate that the causal relationship can move from consumer confidence to market liquidity; in other words, that liquidity fluctuates based off the sentiment of irrational investors. Five years later, then-PhD candidate Shuming Liu used his dissertation to take the next step, arguing that the level of either investor or consumer confidence served as a strong predictor of the level of market liquidity. Liu, now a professor at San Francisco State’s MBA program, found that not only does higher consumer sentiment result in higher liquidity, but that higher investor sentiment results in higher liquidity across small-, average- and large-cap stocks.

Though Liu differs from Berry and Stein’s results with his emphasis on institutional investor sentiment—unsurprisingly, he finds the sentiment of institutional investors to have a greater effect on market liquidity than that of individuals—the two studies combine to provide a strong causal link between positive sentiment and increased liquidity in the stock market.[2]

Though equity trading volumes around the world continue to rise, market liquidity is still well off of its pre-crisis peak, and remains a widespread concern going into the last four months of the year.[3] As all interested parties look forward to try to anticipate the future of stock liquidity, add consumer and investor sentiment to the list of indicators that might provide some insight.



[1] Baker, Malcolm and Stein, Jeremy C. “Market liquidity as a sentiment indicator.” Journal of Financial Markets 7 (2004), 273.
[2] Liu, Shuming. “Two Essays on Stock Liquidity.” Presented at the University of Texas at Austin, 2008. pp. 42-44.
[3] Wigglesworth, Robin. “Liquidity pitfalls threaten parched markets.” Financial Times, 18 June 2015. 00144feabdc0.html+&cd=4&hl=en&ct=clnk&gl=us#axzz3k2omSiUm