UiS Working Papers in Economics and Finance,
University of Stavanger

Abstract: We 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.

Keywords: Market Microstructure; Liquidity; Business Cycle

JEL-codes: E44; G10; G20

41 pages, November 1, 2008

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Published as

Randi Naes, Johannes Skjeltorp and Bernt Arne Odegaard, (2011), 'Stock Market Liquidity and the Business Cycle', Journal of Finance, pages 139-176

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