Stock Market Liquidity, Aggregate Analyst Forecast Errors, and the Economy

Abstract

Naes, Skjeltorp, and Odegaard (2011) suggest that stock market liquidity is a good leading indicator of the economy because of the “flight-to-quality” behavior of informed investors, whose sells (buys) tend to lead stock market liquidity to decrease (increase) and tend to occur before economic downturns (expansions). To further understand the mechanism in the economic forecastability of stock market liquidity, we hypothesize that analyst earnings forecast errors have a systematic component, which is predictable and related to changes in the economy, and that smart investors exploit analyst forecast errors, which leads to the economic forecastability of stock market liquidity. Consistent with our hypothesis, we find that there is a strong correlation between detrended aggregate analyst forecast errors and concurrent GDP growth and that a large part of the forecast errors can be predicted using lagged macro variables. Once we control for the predictable forecast errors, the economic forecastability of stock market liquidity disappears. Thus, our study reveals that aggregate analyst forecast errors are very informative about business cycle and contain all the relevant information for stock market liquidity as a leading economic indicator.