Examining the signals from stocks with low trading volume, the author finds empirical evidence that unusually low trading volume indicates unfavorable changes in the fundamentals of the companies. This effect is more pronounced among stocks with higher short-selling constraints.
The author studies the relationship between unusually low trading volume and company fundamentals as captured by earnings surprises. He provides a vital alternative explanation for the association between low-volume shocks and future returns.
How Is This Research Useful to Practitioners?
Investors and portfolio managers need to understand the effect of low trading volume on future prices in order to make prudent investment decisions. In this study, the author empirically documents the effect of low trading volume on company fundamentals and future returns, which is an unusual approach.
The author constructs dummy variables for unusually low volume and high volume. The low-volume variable equals 1 if a stock is classified as low volume. He captures earnings surprises with three variables. The first variable is standardized unexpected actual earnings using historical accounting information. The second variable is standardized unexpected actual earnings using analyst forecasts. The third variable is based on abnormal stock returns around earnings announcements.
The author includes various control variables: size; ratio of book value to market value; 50-day reference period return, computed over the window before the earnings announcement date; 5-day event period return, computed over the window before the earnings announcement date; the standard deviation of daily returns, calculated over days before the earnings announcement; the firm’s institutional ownership; and average turnover over the reference period. The results indicate that stocks with unusually low trading volume before earnings announcements tend to have significantly lower earnings surprises than stocks with normal or high trading volume, under the first two measures of earnings surprises.
The author presents evidence that stocks with unusually low trading volume over the week prior to earnings announcements are a signal of forthcoming negative information about changes in company fundamentals, as captured by earnings surprises. This effect is more obvious among stocks with higher short-selling constraints.
How Did the Author Conduct This Research?
The data samples for the study cover the period from the second quarter of 1980 to the end of 2011 and consist of 256,864 firm-quarter observations, for an average of 2,023 stocks each quarter. All data samples consist of NYSE, NASDAQ, and AMEX common stocks. The author includes stocks with at least 12 months of return data from CRSP as well as stocks with sufficient data from Compustat to compute the relevant accounting ratios. Illiquid stocks are excluded. He performs cross-sectional regression analysis to control for various stock characteristics that may affect the relationship between volume shocks and an earnings surprise.
The author shows that stocks with unusually low trading volume before earnings announcements signal more unfavorable earnings surprises than stocks without any unusual trading activity or stocks with unusually high trading volume. The results are more pronounced among stocks with higher short-selling restrictions, as proxied by low institutional ownership or the absence of options.
The relationship between unusually low trading volume and future returns has received little attention in the investment world. The author’s findings show that unusually low trading volume is a signal of negative information about company fundamentals, thus affecting future returns. This study fills an important gap in the investigation of low trading volume and its effect on future returns. It could be extended to examine the effect of low trading volume on prices before such unscheduled events as mergers and acquisitions.