The Time-Varying Liquidity Risk of Value and Growth Stocks

We study the liquidity exposures of value and growth stocks over business cycles. In worst times, value stocks have higher liquidity betas than in best times, while the opposite holds for growth stocks. Small value stocks have higher liquidity exposures than small growth stocks in worst times, while small growth stocks have higher liquidity exposures than small value stocks in best times. Combined with the fact that growth stocks have lower market risk than value stocks in bad times (as documented by Petkova and Zhang, 2005), our results are consistent with a flight-to-quality explanation for the countercyclical nature of the value premium. Investors seeking safer assets in bad times may want to liquidate value stocks more aggressively than growth stocks. This increase in selling pressure could make value stocks more sensitive to liquidity risk than growth stocks in recessions. We show that the relative order imbalances of value-minus-growth strategies decreases as economic conditions worsen. This suggests that in bad times investors sell value stocks more aggressively than growth stocks, and this activity results in relatively greater illiquidity in value stocks. Overall, exposure to time-varying liquidity risk, combined with the liquidity price of risk, is able to capture 35% of the small-stock value premium and 100% of the large-stock value premium