Stock Market Liquidity and the Business Cycle

Abstract

In the recent financial crisis we saw the liquidity in the stock market drying up as a precursor to the crisis in the real economy. We show that such effects are not new, in fact we find a strong relation between stock market liquidity and the business cycle. Stock market liquidity worsens when the economy is slowing down, and this effect is most pronounced for small firms. Using data for both the US and Norway, we show that stock market liquidity predicts the current and future state of the economy both in and out of sample. We also show some evidence that can shed light on the link between stock markets and the real economy. Using stock ownership data from Norway, we find that the portfolio compositions of investors change with the business cycle and that investor participation is correlated with market liquidity, especially for the smallest firms. This suggests a "flight to quality" during economic downturns where traders seek to move away from equity investments in general, and within their equity portfolios, move from smaller/less liquid stocks to large/liquid stocks. Overall, our results provide an new explanation for the observed commonality in liquidity.

Keywords: Market Microstructure, Liquidity, Business Cycles

JEL Classification: G10, G20