A Century of Market Reversals--Resurrecting Volatility

Inventory models posit that return autocorrelation is affected by collateral, volume, and expected volatility. We show that daily market autocorrelations are lower on negative return days, consistent with collateral concerns. Unlike previous literature, we document a strong role of volatility on autocorrelation. Puzzlingly, anticipated volume, not volume shocks, drive reversals. Sparked by these findings, we construct a liquidity risk factor in accordance with Pastor-Stambaugh (2003) that is volatility, not volume, based. The volatility-based factor is more robust and has a higher risk premium than the volume-based factor.