Liquidity, Price Behavior, and Market-related Events Ran Lu-Andrews and John L. Glascock Center for Real Estate and Urban Economic Studies, School of Business, University of Connecticut, 2100 Hillside Road, Storrs, CT 06269, USA. E-mails: ran.lu-andrews@business.uconn.edus; john.glascock@uconn.edu We investigate the price behavior of stock market portfolios sorted by liquidity and/or size surrounding strong market events. Our sample includes 74 events that represent return movements for the market that are ±4.5 standard deviations from average returns. None of these market events are associated with explanatory ‘causes.’ Using standard liquidity mea- sures, the Amihud and turnover tests, we find that large liquid stocks react in a stronger manner to market shocks. In addition, these stocks experience faster reversal following the shocks than do illiquid and small stocks. We interpret this as indicating that large liquid stocks are more market related. We also find that small illiquid stocks have more idiosyncratic risk than liquid and large stocks. These outcomes have implications for investors wanting to construct portfolios to mimic the market and also for portfolios that might be expected to move more (or less) strongly during market events. Eastern Economic Journal (2016). doi:10.1057/s41302-016-0002-0 Keywords: liquidity; size; market events; price behavior; market risk JEL: G11; G12; G14 INTRODUCTION The United States stock market persistently experiences significant extreme event shocks. For example, between 1950 and 2008, there were 20 times that the stock market gained at least 4.5 percent and 26 times that the market lost at least 4.5 percent in a single trading day. During the 1980s, there were seven such events, and during the 1990s, there were three such events. Some of these shocks are associated with market information events such as industry accidents [Hill and Schneeweis 1983; Maloney and Mulherin 2003; Laguna 2009] or political turmoil [Niederhoffer 1971] or rare disasters [Gu and Schinski 2003; Barro 2006, 2009; Bianchi 2010], but many are associated with what we label as statistical events. These statistical events are strong [in this case, we use 4.5 standard deviations of price movement as a benchmark], and occur frequently. For example in the 1980s, there were seven times that the market reacted by over/under 4.5 percent, and there was no known associated economic event. In this research, we examine the excess return behavior of stock portfolios sorted by size [measured by market capitalization] and liquidity [measured by Amihud illiquidity ratio and turnover] around these statistical market-related events. These events tend to be associated with price reversals. Campbell et al. [1993] suggest that after the movement away from fundamentals, the provision of liquidity induces price reversals. Empirically, we observe that prices reverse in the short run [for example, Lehmann 1990; Jegadeesh 1990; Avramov et al. 2006]. There are alternative explanations as to why stocks prices reverse. Some argue that it is due to uninformed and liquidity trading. Campbell et al. [1993] build a model which implies that noninformational trading causes prices to deviate from their fundamentals. Risk-averse Eastern Economic Journal, 2016 Ó 2016 EEA 0094-5056/16 www.palgrave-journals.com/eej/