Lagged order flows and returns: A longer-term perspective

In this paper, we consider the large-sample relation between returns and lagged order flows over horizons of up to 2 months. The analysis is motivated by work in market microstructure which suggests that the effects of inventory control on stock returns should be discernible over horizons longer than those considered in the literature. We begin our analysis by developing a simple model of inventory effects in the presence of public information. Using mid-quote return data, we then find some evidence of return predictability using order flows, even after controlling for lagged returns, which is consistent with our theoretical setting. The relation is present only for negative imbalances and is stronger in large firms rather than small ones. Overall, the analysis is consistent with the notion that inventory control effects span several weeks. (C) 2006 The Board of Trustees of the University of Illinois. Published by Elsevier B.V. All rights reserved.