Does stock market liquidity predict the business cycle?

Academics and researchers across the world have been dealing with the identification of factors and variables that can prove to be leading indicators for future macroeconomic growth and the business cycle. One strand of literature, based on the notion that stock prices are equal to the expected value of future income, proposes that asset prices should contain information about future growth in the economy. In this line a number of variables have been identified that forecast the business cycle such as common risk factors that predict stock returns, interest rates, term spreads and exchange rates.

In the present research we focus on the liquidity of the stock market, which proxies for the implicit cost of trading shares, and examine whether there is a strong relationship between stock market liquidity and the business cycle. This relationship has not attracted a great deal of attention in the literature and especially the causality of this relationship; in other words the issue of how aggregate market liquidity affects the future conditions of the real economy.

In doing so, we estimate four different liquidity proxies, Amihud’s (2002) illiquidity ratio, relative spread, turnover and volume of trading. All four liquidity proxies are first estimated for each stock for each quarter and then the equally weighted cross-sectional average for each quarter is calculated. The setting of the study is the two largest stock markets in Europe in terms of capitalization and number of companies listed, the London Stock Exchange and the Deutsche Börse from 1994 to 2011 and 1999 to 2011 respectively.

We regress four different measures of economic activity, real GDP, real Consumption, real Investment and the Unemployment Rate against the liquidity proxies and three control variables, the term spread, the market risk premium and the stock market volatility, using different specifications of the empirical model and we perform Granger causality tests between the liquidity measures and the macro variables to ensure the robustness of our results.

The empirical results show that aggregate stock market liquidity contains strong and robust information about the future state of the business cycle. Furthermore, the relationship remains stable for all liquidity proxies and for both markets examined, i.e. U.K. and Germany.