Liquidity Shocks and Stock Bubbles

This study presents and empirically tests a simple framework that examines the effects of market liquidity (the ease with which stocks are traded) and funding liquidity (the ease with which market participants can obtain funding) on stock market bubbles. Three key findings emerge from this research. First, negative market and funding liquidity shocks increase the probability of stock market bubbles collapsing. Second, market liquidity has a more prevalent effect on stock bubbles than funding liquidity. Third, liquidity shocks provide warning signals of impending bubble collapses. A trading rule based on recursive forecasts from the aforementioned framework is used to illustrate the economic significance of the liquidity-bubble relationship.