Liquidity and the Business Cycle
AbstractWe show evidence of a contemporaneous relation between stock market liquidity and the business cycle. Stock market liquidity worsen when the economy is slowing down, and vice versa. This effect is most pronounced for small firms. Using data for both the US and Norway, we find strong evidence that stock market liquidity predict the current and future state of the economy. 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. Our results suggests a flight to quality during economic downturns where equity traders move from smaller/less liquid stocks to large/liquid stocks. Our results suggest that an important explanation for the equity premium in general, and the equity size premium in particular, may be related to time variation in stock market liquidity at business cycle frequencies.
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Bibliographic InfoPaper provided by University of Stavanger in its series UiS Working Papers in Economics and Finance with number 2009/1.
Length: 41 pages
Date of creation: 01 Nov 2008
Date of revision:
Publication status: Forthcoming in Journal of Finance.
Market Microstructure; Liquidity; Business Cycle;
Other versions of this item:
- E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
- G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
- G20 - Financial Economics - - Financial Institutions and Services - - - General
This paper has been announced in the following NEP Reports:
- NEP-ALL-2009-04-18 (All new papers)
- NEP-MAC-2009-04-18 (Macroeconomics)
- NEP-MST-2009-04-18 (Market Microstructure)
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