We estimate an ex ante probability of extreme negative returns (crashes) of individual stocks as a measure of potential overpricing and find that stocks with a high probability of crashes earn abnormally low returns. Stocks with high crash probability are overpriced regardless of the level of institutional ownership or variations in investor sentiment, and moreover, they exhibit increasing institutional demand until their prices reach the peak of overvaluation. We also find that institutional investors who overweight high crash probability stocks outperform the others, indicating that they have skill in timing bubbles and crashes of individual stocks. Our findings imply that sophisticated investors may not always trade against mispricing but time the correction of overpricing, and suggest that the crash effect we find could arise at least partially from rational speculative bubbles, not entirely from sentiment-driven overpricing.

Recent evidence on state-dependent variations in market liquidity suggests strong variations in the illiquidity premium across economic states. Adopting a two-state Markov switching model, we find that, while illiquid stocks are affected more by economic conditions than liquid ones are during recessions, the differences in expected returns are relatively small during expansions. Therefore, the expected illiquidity premium displays strong state-dependent variations that are countercyclical. We show that the state of a high illiquidity premium is closely associated with periods of real economic recessions, market declines, and high volatility, which coincides with major events of liquidity dry-up and high liquidity commonality.