Do supply and demand drive stock prices?

Abstract

In this paper, I find that the imbalance between buy and sell orders explains most of the stock price changes. I then show that this effect is driven largely by uninformed price pressure, and not only by private information. To obtain that result, I first establish that causality goes from orders to price. I then distinguish between private information and uninformed price pressure by looking at the implications of a private information model. For idiosyncratic returns, where one would expect private information to be important and the R 2 of return on order flow to be high, the R 2 is indeed around 41%. However, for the common market return, where one would expect private information to be minor, the R 2 is even higher at 70%. This argues against private information and in favor of uninformed price pressure. Moreover, the 70% of the market return that is generated by the order flow imbalance is too high not to include some transitory components of the market return, as defined in the literature on long-term mean reversion. This means that the order flow temporarily moves stock prices away from their fundamental value. This paper points toward a bigger role for uninformed price pressure than is usually assumed.