Predicting US Recessions with Stock Market Illiquidity

Understanding the Macroeconomic Impact of Illiquidity Shocks in the United States

“…In sum, according to our historical decomposition analysis, we found that illiquidity shocks explain quarterly economic activity in recession periods well in terms of magnitude and direction. This confirms the view of Chen, Chou, and Yen () that the dynamic link between recessions and stock market liquidity is strong, and it also echoes the findings in Ellington, Florackis, and Milas () and Ellington () that the magnitude of the effect of illiquidity shocks on real GDP is likely to be greater in recession periods.…”

“…Figure shows that illiquidity shocks explain the swings in economic activity better in recessions than in normal times. As shown in Næs, Skejeltorp, and Ødegaard () and Chen, Chou, and Yen (), because small firms are relatively more sensitive to economic downturns than large firms, it is more likely that investors move away from stocks with lower liquidity when the economy is in recession, and the size of the liquidity shock to small firms should decline substantially to reflect this “flight to liquidity” effect. Thus, it is of interest to examine stock market illiquidity shocks arising from different firm size quartiles and compare the differences between the shocks arising from large firms and small firms in terms of size and quantitative importance.…”

“…We then use the averaged stock market illiquidity measure ILR t to conduct the empirical analysis. We follow Næs, Skejeltorp, and Ødegaard () and Chen, Chou, and Yen () in scaling up ILR t by multiplying by 10 6 because the original magnitude of the ILR t measure is too small to conduct a sensible empirical analysis.…”

“…Florackis et al () find a statistically significant negative relationship between stock market illiquidity and future UK gross domestic product (GDP) growth. Furthermore, Chen, Chou, and Yen () also demonstrate that the stock market illiquidity ratio is a strong predictor of future recessions. Ellington, Florackis, and Milas () use a Bayesian time‐varying parameter vector autoregression (TVP‐VAR) with stochastic volatility to investigate illiquidity shocks to the stock market and housing market on real GDP in the United States.…”

“…Declines in liquidity in equity markets became an important issue following the 2008–2009 financial crisis, as well as other recession periods dating back to the 1950s (Chen, Chou, and Yen ; Chen, Eaton, and Paye ; Næs, Skejeltorp, and Ødegaard ). There are a number of ways that stock market liquidity can affect the real economy.…”