Dr. Saumya Ranjan Dash
Finance & Accounting Area, IIM Indore
Email: firstname.lastname@example.org; Phone: 0731-2439667
Apart from the macro-economy related fundamental factors, a possible impact of investor sentiment on financial market behaviour has been a subject of considerable interest to both economists and practitioners. Over the past decades, the grievous socioeconomic consequences of market crashes, and the failure of traditional theories to provide convincing explanations for such market behaviour have made both academic and practitioners to question the complete rationality assumption of investor behaviour. Following the arguments of noise trading, irrational behaviour of market participants the proponents of behavioural finance theories try to analyse the role of investor sentiment in the context of irrational exuberance of the market with unanticipated boom and bust cycles. In recent years, using behavioural finance literature, academic research tries to answer one of the most important aspects of financial market stability, i.e., stock market liquidity. Existing literature suggests that investors’ trading behaviour based on noise, overconfidence, and disposition effect can influence sentiment in the market, which subsequently can affect liquidity. Since the impact of noise trading on financial stability is negative, and high noise trading can influence liquidity, the sentiment liquidity relationship is a pertinent research question from a policy perspective.
This study examines the impact of local and foreign investor sentiment on stock market liquidity. In particular, this study examines the impact of investor sentiment on the stock market liquidity of 12 emerging markets (Brazil, China, India, Indonesia, Mexico, Philippines, Poland, South Africa, South Korea, Russia, Thailand, and Turkey). These 12 ESMs were chosen because they are consistently recognized as a suitable equity asset class in various international indices, such as the MSCI, FTSE, Standard & Poor’s, and Dow Jones emerging market indices. We use three liquidity measures to control for trading frequency, price-impact characteristics, and transaction-cost aspects. We use consumer confidence index data for country-specific sentiment measurement and sentiment measures of US and European market as international sentiment measures.
Our analysis reveals that an increase (decrease) in sentiment enhances market liquidity (illiquidity). Overall results suggest that apart from macro-economic fundamental factors (monetary policy, inflation, industrial production, market return etc.) the impact of investor sentiment is an important determinant of stock market liquidity. It has been observed that when sentiment is positive, stock-market liquidity increases significantly. Empirical analysis suggests that the liquidity dry-up or increase in illiquidity is more prevalent in a pessimistic sentiment as compared to optimistic sentiment periods for the liquidity creation. Overall results indicate that sentiment is an essential factor for stock-market liquidity, despite the fact that the magnitude of this effect varies from country to country. We find that for countries like Indonesia, Mexico, Poland, South Africa, South Korea, Thailand, and Turkey investor sentiment is more important for stock market liquidity. Accordingly, investor sentiment is more important for the stock market illiquidity of countries like Brazil, India, Indonesia, Mexico, Poland, South Africa, and Turkey.
Results also reveal that developed market investor sentiment (the US and Europe) matters for emerging market liquidity. Considering the 2008-2009 global financial crisis as an important economic event, the positive (negative) impact of sentiment on stock-market liquidity (illiquidity) is persistent in both the pre-financial crisis and post-financial crisis period. Furthermore, in our subsequent analysis, we observe that sentiment has a positive (negative) effect on stock-market liquidity (illiquidity) even after controlling for the stock-market development indicators like government effectiveness, regulatory quality, the rule of law, economic freedom, financial market efficiency, and size of the stock-market. Our results are consistent with the theoretical framework which suggests that due to disposition effect during bullish sentiment trading volume and hence stock-market liquidity tends to grow. On the other hand, liquidity tends to fall when the market turns south due to pessimism.
ORIGINAL ARTICLE: Debata, B., Dash, S. R., & Mahakud, J. (2018). Investor sentiment and emerging stock market liquidity. Finance Research Letters, 26, 15-31.