Stock Market Liquidity and the Business Cycle

35 Pages Posted: 11 Jul 2008 Last revised: 9 Mar 2010

See all articles by Randi Naes

Randi Naes

Norwegian Ministry of Trade and Industry

Johannes Atle Skjeltorp

Central Bank of Norway

Bernt Arne Ødegaard

University of Stavanger

Date Written: February 10, 2010

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

Suggested Citation

Naes, Randi and Skjeltorp, Johannes Atle and Ødegaard, Bernt Arne, Stock Market Liquidity and the Business Cycle (February 10, 2010). Journal of Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=1158408 or http://dx.doi.org/10.2139/ssrn.1158408

Randi Naes

Norwegian Ministry of Trade and Industry ( email )

P.O. Box 8014 Dep
N-0030 Oslo
Norway
+47 22 24 04 34 (Phone)
+47 22 42 40 62 (Fax)

Johannes Atle Skjeltorp (Contact Author)

Central Bank of Norway ( email )

P.O. Box 1179
Oslo, N-0107
Norway

HOME PAGE: http://www.norges-bank.no/research/skjeltorp/

Bernt Arne Ødegaard

University of Stavanger ( email )

UiS Business School
Stavanger, NO-4036
Norway

HOME PAGE: http://ba-odegaard.no

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
834
Abstract Views
3,704
Rank
59,405
PlumX Metrics