As investors and traders continue to take a beating from the markets, most are anxiously awaiting yet another interest rate cut by the U.S. Federal Reserve. Some speculate that the Fed may move to slash rates by as much as a half-point before the end of June. A deep rate cut seems a likely step to boost liquidity for the lagging financial markets.

A drop in the interest rate could also help stimulate the sagging U.S. economy, as many key business sectors continue to show flat or weakening activity. This month, the Fed announced that "economic activity was little changed or decelerating in April and May" for most parts of the country. Construction, tourism, manufacturing, and retail showed signs of slowing or flat growth.

Tarun Chordia, who teaches finance at Emory University’s Goizueta Business School, believes that the Fed’s interest in the market’s liquidity is essential. He notes: "Liquidity is the grease that facilitates the smooth functioning of markets. The Federal Reserve is very concerned about liquidity, so much so that it intervened during the 1998 crisis involving Long-Term Capital Management [a troubled hedge fund]." Chordia also points to the Fed’s interest rate cuts shortly after the 1987 stock market crash and the 1997 Asian crisis. One of the reasons for the rate slash was, simply put, to stimulate liquidity in the markets.

Today the availability of liquidity remains an important issue in the stock market’s performance. Chordia believes that order imbalance, an important facet of liquidity, can provide significant information on market returns. An order imbalance exists when buy orders on a particular stock exceed sell orders, or the converse.

As a control mechanism, the stock market allows a specialist or market maker in a particular stock to increase or lower the bid-ask price, to encourage a balance between sellers and buyers. The specialist must buy or sell the excess shares, however, if the price change does not resolve the imbalance. Consequently, Chordia notes that order imbalance exerts significant influence on stock returns and liquidity.

In a new research paper, Chordia and co-authors Richard Roll, a professor of finance and insurance at the University of California at Los Angeles’ Anderson Graduate School of Management, and Avanidhar Subrahmanyam, a professor of finance also at the Anderson Graduate School, take an in-depth look at the long-term effects of order imbalance on liquidity and market returns. The authors used estimated market-wide order imbalances on a given day "for a comprehensive sample of New York Stock Exchange stocks during the period 1988-1998."

Specifically, the S&P 500 served as the representative stock market index for the purposes of the research. The researchers used data from the Institute for the Study of Security Markets for the years 1988 to 1992, and from the New York Stock Exchange’s trades and automated quotations database for the years 1993 to 1998. In all, 2,779 observations were provided on average daily order imbalances from the S&P 500 stocks. Then, the authors measured order imbalance by the number of transactions, shares, and dollars involved, against liquidity and daily stock market returns.

The researchers found that not only does order imbalance impact liquidity and returns for a particular stock, but that the effect occurs on the "aggregate market level" as well. Additionally, the paper points out that "excess sell orders have an impact four times that of excess buy orders." The concern created by a major sell-off often contributes to the increased impact on the sell side. Chordia, Roll and Subrahmanyam note that order imbalances often indicate that private information about a stock has leaked to some investors. Even sizeable, but random, large order imbalances may cause an inventory crunch for the market maker.

The authors’ research also proves a widely accepted financial theory---that investors are contrarian by nature. Specifically, the paper notes, "Signed order imbalances increase (decrease) following market declines (rises)." Chordia says: "When markets drop, people start buying. This gives you an idea of the contrarian theory in the markets. People are rushing to provide liquidity." Regardless of an up or down market, the paper states that the contrarian reaction lasts for up to three days.

Chordia admits, however, that "while contemporaneous order imbalance does exert a significant impact on market returns suggesting price pressures due to trading, the S&P 500 is still unpredictable at the daily frequency." In addition, the research shows that market returns offer some insight into liquidity, but past imbalances do not provide predictable information on it. Still, the authors’ research illustrates a "very strong contemporaneous association between changes in the absolute level of market-wide order imbalance and market-wide liquidity." The information becomes particularly useful for those looking to stay on top of research critical to trading strategy design.

Chordia also believes that the study of investor behavior can be particularly important to market makers. He explains: "Higher order imbalance implies higher spreads and lower liquidity." For the most part, Wall Street investors are creatures of habit, with liquidity tracking closely to prior market shifts. The authors note: "A down market predicts low liquidity (higher spreads) the next day. An up market also predicts higher liquidity the next day, though the magnitude of the effect is much smaller than for a previous down market."

Fortunately, the research indicates that the market remains self-correcting, to a large degree. The authors add: "Temporary inventory imbalances and consequent price pressures are countervailed effectively by astute traders." Chordia adds: "It is quite nice to find that the market is efficient, as a whole."

Certainly, say the researchers, the long-range study of order imbalance provides significant data on the behavior of the market. Chordia believes that "order imbalance may be able to offer some clues as to what the market expects" from major economic announcements, such as a release of unemployment or GDP figures, for example. Ultimately, the information could answer some of the economic questions that are relevant to investors, exchanges and regulators alike. The authors conclude: "Order imbalances around major macroeconomic announcements could help shed additional light on the information paradigm by ascertaining whether agents are able to predict the sign of the impending announcement."