Illiquidity may signal trouble.

Photographer: Karim Sahib/AFP/Getty Images

Bear Markets Don’t Predict Recessions, But Liquidity Might

Stephen Mihm, an associate professor of history at the University of Georgia, is a contributor to the Bloomberg View.
Read More.
a | A

As the world’s equities markets are buffeted by bouts of intense volatility, analysts have started uttering a chilling phrase: bear market. China's markets have entered this territory, and the U.S. might not be too far behind.

That possibility invariably leads to speculation that the declines are harbingers of worse to come, in other words, a recession. This question has attracted relatively little attention from economists and scholars, perhaps because of a memorable takedown by Paul Samuelson. In a Newsweek column in 1966, the famed economist famously quipped that bear markets had a remarkable record as a leading indicator, having predicted “nine out of the past five recessions!”

It’s a great joke. And certainly, when it comes to the somewhat exceptional period of economic history between the Great Depression and the most recent recession, other leading indicators have a better track record of predicting the future. The yield curve, for example, has predicted all U.S. recessions except one since 1950.

But this does not mean that stock market turmoil is irrelevant to the larger economy. For example, the economists Arturo Estrella and Frederic Mishkin published an article in 1998 that examined the predictive power of a range of leading indicators in the postwar era.  After crunching the historical data, they concluded that “the yield curve spread and stock price indexes emerge as the most useful simple financial indicators,” and that when combined, offered a leading indicator more accurate than either one alone.

Other researchers have corroborated these findings, and established that stock market performance has some predictive power, though it also has generated its fair of false alarms. A historical study by Harvard’s James Stock and Princeton’s Mark Watson reviewed the relationship between equities prices and economic output in seven developed nations between 1959 and 1999. They concluded that “some asset prices have substantial and statistically significant marginal predictive content for output growth at some times in some countries.”

Now that’s what you call hedging. In any case, their findings didn’t exactly constitute a ringing endorsement of stock prices as a crystal ball for seeing recessions on the horizon.

But there’s another way that the behavior of the stock market may be a harbinger of things to come. A 2010 paper published by three Norwegian economists -- Randi Næs, Johannes A. Skjeltorp and Bernt Arne Ødegaard -- zeroed in on “market liquidity.”

In a liquid market, stocks can be bought and sold without significant alterations of the existing price. For example, someone attempting to sell shares will find buyers above and below the asking price, and the transaction itself doesn’t dramatically impact the existing price. An illiquid market, however, exhibits the exact opposite set of tendencies: trades tend to distort the price because the market doesn’t have the same depth and breadth on both sides of the trade. Put differently, a liquid market is one with a healthy cacophony of asks and bids. An illiquid market is the financial equivalent of crickets chirping.

There are different ways of measuring liquidity (or illiquidity). The most obvious is to calculate the change in price per unit of trade volume. These estimates come in a variety of flavors. The best known, perhaps, is the Illiquidity Ratio, or ILR, devised by Yakov Amihud, a professor at NYU’s Stern School of Business. And this is what the Norwegian economists used to examine the historical data, though they also relied on several other comparable measures of stress in the markets, or illiquidity.

Examining data from 1947 to 2008, the researchers found that “market liquidity seems to be a particularly strong and robust predictor of real GDP growth, unemployment and investment growth.” Conversely, rising levels of illiquidity consistently signaled that a recession was on the horizon. There were a few false alarms, but in general the evidence is rather striking.

Why would an insufficiency of buyers and sellers be a sign of anything? The authors speculated that rising illiquidity may be a symptom of a “flight to quality” symptomatic of growing pessimism about the direction of the economy. Given that this translates to a move from the stocks of small, more risky companies to big, blue chip ones, the authors focused on these smaller firms. They found the illiquidity of these stocks was “most informative about future economic conditions.” The predictive power of liquidity was even more pronounced.

All of which raises the question of the hour: What are the markets doing now? Try to figure it out for yourself. The raw data you need to construct a measure of illiquidity is available at the Center for Research in Security Prices at the University of Chicago’s Booth School of Business.

Have at it.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Stephen Mihm at

To contact the editor responsible for this story:
Max Berley at