Target prices, relative valuations and the compensation for liquidity provision

We document that short-run deviations between prices and fundamentals can be identified in real time using equity analysts’ target price forecasts. While a given target price itself need not provide an accurate estimate of true fundamental values, relative valuations of firms within an industry, on average, are more precise. This finding allows us to disentangle information and liquidity induced short-run price movements by providing a control for changes in fundamental values. The short-run deviations from fundamental values are economically and statistically significant and of a magnitude not easily explained by transaction costs alone. We find that the risk-adjusted return earned by our benchmark portfolio of S&P500 stocks is highly correlated with standard cross-sectional measures of liquidity such as the bid-ask spread, price impact and changes in signed trading volume. Our findings point to a significant premium required by investors for providing immediacy even in the market for the most liquid stocks. JEL Classification: G12 ∗We would like to thank Kathleen Hagerty, Robert Korajczyk, Robert McDonald, Avanidhar Subrahmanyam, seminar participants at Goldman Sachs Asset Management, HEC Montreal, University of Notre Dame, Northwestern University, Vanguard and especially Ravi Jagannathan for his numerous suggestions and insights. We gratefully acknowledge financial support from the Financial Institutions and Markets Research Center at the Kellogg School of Management. † [email protected], University of Notre Dame. ‡ [email protected], Kellogg School of Management, Northwestern University. 1 10:30 am – 12:00 pm, Room: JKP-202 FRIDAY, October 27, 2006 USC FBE FINANCE SEMINAR presented by Ernst Schaumburg