Dash for Cash: Month-End Liquidity Needs and the Predictability of Stock Returns
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19 November 2014
This paper uncovers strong return reversals in stock returns around the last monthly settlement day, T-3, which guarantees liquidity for month-end cash distributions. We show that these return reversals are stronger in countries where the mutual fund ownership is large, and that in the US the return reversals have become stronger over time as the mutual fund ownership of stocks has increased. Finally, in the cross-section of stocks, the reversals around turn of the month are stronger for stocks more commonly held by mutual funds, for liquid stocks, and for more volatile stocks (controlling for liquidity).
Month-End Liquidity Needs and the Predictability of Stock Returns – Introduction
It is surprising how little attention academic literature has devoted to understand equity market returns around the turn of the month, despite the observations of Lakonishok and Smidt (1988) and McConnell and Xu (2008) among others that most of the returns accrue during a four-day period, from the last trading day to the third trading day of the month. We find that the market returns are abnormally high also on the three days before the turn of the month. In fact, combining the two observations, we find that since 1926, one could have held the S&P 500 index for only seven business days a month and pocketed almost the entire market return with forty percent lower volatility compared to a buy and hold strategy. Since 1987, all of the positive equity returns have accrued during these seven trading days, and the average returns during the rest of the month have been negative. Odgen (1990) relates the high returns at the beginning of the month to the monthly payment cycle – the fact that large part of investors’ cash receipts are obtained on the last or the first business day of the month. Our findings lend additional support to this hypothesis.
In this paper, we explore the turn of the month phenomenon further and discover new, previously unidentified patterns in equity returns. Our findings concern not only the returns
after the turn-of-the month, but also those immediately preceding it. In particular, we uncover strong return reversals in stock market returns around the last monthly settlement
day, T-3, which guarantees liquidity for month-end cash distributions. In addition, our research sheds light on the forces behind the stock return predictability around the turn of the month. Besides confirming the importance of the payment cycle as a determinant of the turn-of-the-month return patterns, our results suggest that agency reasons such as “window dressing” within the mutual fund industry (e.g., Lakonishok, Shleifer, Thaler and Vishny, 1991) play a role.
We begin our study by investigating the potential market implications of the turn of the month payment cycle of pension funds, mutual funds, corporations and other institutions.
Due to this cycle, potentially billions of dollars invested in the stock market get liquidated every month just a few days prior to the month end and distributed as cash to pensioners, employees, and recipients of corporate or mutual fund dividends. In order to meet their month-end cash liabilities on time, all institutions and individuals whose liquid funds are invested in the equity market must sell their stocks at least three business days before the month end, following the most common settlement rule of the developed stock markets. As a result, for some time period preceding the third business day before month end, which we label T-3 (here T refers to the last day of the month), the market must absorb a large amount of order flow to accommodate the sellers’ liquidity needs. Under perfectly efficient markets, market makers and speculators would ensure that prices are barely affected by such sell orders, which do not reflect any investment views. However, in the absence of sufficient speculative capital, it is likely that market prices get temporarily depressed due to the selling pressure and that it takes some time for prices to revert back to their fundamental values. This is the main hypothesis we investigate in this paper. Similarly, at the beginning of the month, buying pressure from the recipients of the turn of the month payments can lead to temporary overvaluation of the stock market that reverts over time. We also explore this idea in our paper.
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