Do stock market trading activities forecast recessions?

This paper re-examines the existing recession forecasting models with stock market liquidity as an additional forecasting variable. We investigate three distinct aspects of stock market trading activities, namely stock market liquidity, returns and volatility as predictors of U.S. recessions. We also conduct a horserace comparison in the recession forecasting power between various stock market liquidity measures. We show that i) lower stock market liquidity signals recessions; ii) stock market liquidity (returns) forecasts recessions up to three quarters (two quarters) into the future, while stock market volatility has no forecasting power; iii) stock market liquidity as computed by stock transaction costs and by stock price changes to trading volume forecast recessions better than other measures in the literature; iv) stock market liquidity-based models outperform the survey of professional forecasters' estimates of recession probabilities, and hence the results suggest that professional forecasters may need to incorporate stock market liquidity in their forecasts. The results have potential preemptive monetary policy implications. (C) 2016 Elsevier B.V. All rights reserved.