This paper focuses on explaining the effect of liquidity shocks on asset prices. This is the first paper that finds that negative liquidity shocks lead to lower stock prices in the short run; yet the initial underperformance only lasts for short period and is reversed in the longer time horizon....

We find that the stock-level liquidity shock bears information about the firm's future fundamentals. Firms with improving (deteriorating) liquidity reveal better (worse) future fundamentals following the liquidity shock. The finding explains the predictability of liquidity shocks on future stock...