Wednesday, March 17, 2010

Finding “Liquidity” in the News

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When constructing trading or investment strategies, distinguishing between companies that can be considered "liquid" or "illiquid" in the news can be important. Not surprisingly, studies have shown that a high correlation exists between market capitalization and news flow, which may be explained by the increased attention given to large-cap companies from research analysts and financial journalists. For this reason, the characteristics of news flow for liquid and illiquid companies may be very different. For example, most publicly traded companies are covered to some degree during the earnings season. However, throughout the year small and mid-caps will have relatively low news volume while large-caps will be better covered.

Considering the S&P500, which are all considered large cap companies, I analyzed news data over the past 5 years and found that about 50% of stocks have less than 15 highly relevant news events on average per month, while about 9% have less than 5 news events, and about 5% of companies have close to zero or no news. Hence, illiquid companies also exist amongst large-cap companies.

I find “news liquidity” to be an important factor when modeling a stock and constructing sentiment indicators. News liquidity is about relevant news volume and the roles companies play in stories - not mere counts of mentions or keywords. Both scheduled and unscheduled company-related events generate higher news volumes and make stocks more susceptible to price movement. Thus, news liquidity can provide insights on directional price changes but also on stock volatility and trading volume/liquidity.

For less liquid companies in the news, one can also use similar or related companies as proxies for sentiment. For example, the industry or sector level sentiment indicators can then be used to form opinions about the return expectations of stocks for news illiquid stocks. That is, given that there is no company-specific news about a given stock, its price may simply be driven by sector or market news sentiment. Also, bad news for one company might lead to a price drop in another and vice versa. Bad news for a sector may signal the beginning of a downtrend in an industry or market.

Other considerations may include the reaction pattern to company-specific events. That is, when a particular type of event (i.e. earnings, product recalls, etc.) occurs - will the price reaction be similar for liquid vs. illiquid companies?

Academic studies have primarily been focusing on distinguishing between large cap and small cap companies [for instance, see "Stock Price Reaction to News and No-news: Drift and Reversal After Headlines"]. Now, you can think of news liquidity as another way to distinguish, relate, and group different types of stocks.