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Faculty Working Papers
I
DIFFERENTIAL CHANGES IN EXTERNAL MARKET
LIQUIDITY
Frank K. Reilly and James A. Gentry
#426
College of Commerce and Business Administration
University of Illinois at Urbana-Champaign
FACULTY WORKING PAPERS
College of Commerce and Business Administration
University of Illinois at Urbana-Champaign
_ •*■* "
August 20, 1977
DIFFERENTIAL CHANGES IN EXTERNAL MARKET
LIQUIDITY
Frank K. Rellly and James A. Gentry
#426
ABSTRACT
DIFFERENTIAL CHANGES IN EXTERNAL
MARKET LIQUIDITY
External market liquidity refers to the ability to buy or sell an
asset quickly with little price change. Using a market liquidity measure
developed by Ami vest Corporation, there is an analysis of aggregate market
liquidity during the period 1969-1975. Subsequently, using two saniples
of 24 larger firms and 24 smaller firms, there is a comparison of the
levels of liquidity and a comparison of changes in liquidity for the two
samples during this period.
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DIFFERENTIAL CHANGES IN EXTERNAL
MARKET LIQUIDITY*
Frank K. Reilly
James A. Gentry**
INTRODUCTION
External market liquidity refers to the ability to buy or sell an asset
quickly with little price change assuming no new information. This character-
istic is important to all investors becaase the lack of it can increase the
cost of an asset to the purchaser or decrease the revenue to the seller of
an asset. This attribute has become important to portfolio managers of large
institutions concerned with the ability to buy or sell blocks of stock [4, 6, 7).
Because institutional investors are the dominant force in the secondary
market, market liquidity becomes important for the financial manager con-
sidering new external equity capital. If a company's stock does not enjoy
a liquid secondary market, it is unlikely the company can sell a new primary
issue. In addition, a poor secondary market can add to the risk of the stock
and increase the firm's required rate of return on equity.
The purpose of this paper is threefold. The first is to discuss a
measure of external market liquidity that can be used to examine changes in
liquidity for the aggregate stock market and for individual stocks. The
second purpose is to examine this liquidity measure for the aggregate market
*The authors acknowledge the assistance of Milan Saric and Paul Skelton.
**The authors are Professors of Finance, University of Illinois at Urbana-
Champaign.
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over time and demonstrate how external market liquidity has varied. Finally,
there is an anlysis of market liquidity for two samples of individual firms.
The samples include 24 larger firms from the top of the Fortune 1000 list and
a san5)le of 24 smaller firms from the bottom of the Fortune 1000 list. The
liquidity measure for the two different samples is examined over time in
order to provide answers to two questions of concern to portfolio managers
and corporate financial managers. First, is there a significant difference
in the average level of market liquidity for large and small firms? The
general consensus is that larger firms enjoy a higher level of market
liquidity. If so, it should be of interest to know how much higher. The
second question is concerned with changes :'n the level of market liquidity
for the two saniples during the period 1?59-1975. Some observers have specu-
lated that since 1939 there has been a uifforential change in market liquidity
for large versus small fims because of the en-ergence of a tiered market.
AGG?.EGATE STCCK MARK3T LIQUIDITY
A Liquidity Measui-e
As noted, market liquidity is the ability to buy or sell an asset
quickly with little price char.ge. Given this definition, the important
attributes that require measureiTient are the tirr.s involved in a trade and
the price change. Generally, information re^^rding the time required to
complete a trade is not available. Fortunately, the time variable is pro-
bably not a crucial requirement becauee nest trades not involving large
"blocks" of stock (10, COO shai-es ci- more) are corcpieted rapidly — in less
than an hour, and in met instances in less th?.n 15 minutes. Therefore,
the time dimension is relatively constant. Kence the price change becomes
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the variable of importance, but it is not simply price change. Not all trades
are of equal size in terms of the number of shares involved and/or the value
of the trade. Clearly one should relate the price change to the amount of
trading. Such a measure has been developed by the Ami vest Corporation, a
New York research firm. The specific measure is derived daily for all stocks
on the NYSE and the ASE and an unweighted average for all stocks is computed.
The average of the daily values for a month is used as the monthly figure.
The computation for each stock is as follows [2]:
. . ^ * T J Dollar Volume of Trading
Amivest $ Index = t; ^ ■ „ ■ . -^^ ,.,.^, — ~^. —
Percent Price Change Without Sign
This measure indicates the value of trading for every 1 percent price
change. The larger the value of the index, the more trading that is possible
without a major price change. Such a series for the aggregate market was
not available prior to 1973 so it was necessary to derive a proxy. Such a
proxy series was developed as part of another study for the period 1964-1975 [9]
The proxy series was computed monthly as:
. . * * T J Dollar Value of Trading on the NYSE
Amivest $ Index = -z, .. ^ . . — r; ■ ^ ■ — ^=^ t — er- —
Sum of Daily Percent Price Changes w/o Sign
In addition, because some portfolio managers might conceive of liquidity
in terms of how many ehares can be traded, a share index was computed that
indicates the number of shares traded per 1 percent change in price. It was
computed as follows:
, Total Reported Shares Traded on NYSE
Amivest bnare index - ^^ ^^ ^^^^^ Percent Price Changes w/o Sign
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These measures can also be used to measure the liquidity for individual
securities over time. In fact, this is the major use made of the liquidity
measure by the originators [2]. In a subsequent section these liquidity
measures are used to examine the level of liquidity and changes in liquidity
for a sample of larger firms and a sample of smaller firms.
Aggregate Liquidity Over Time
Exhibits 1 and 2 contain a monthly time series plot of the two Amivest
liquidity measures for the period January, 1969 -December, 1975. Exhibit 1
contains the dollar index and indicates significant variation over time
from a low of .19 ($190,000) during the latter half of 1974, to a high of
almost 2.5 ($2,500,000) during the first half of 1972. Not only is there a
wide range of values, but there was substantial variability over time on a
month- to- month basis. The point is, the plot indicates that external market
liquidity for the total stock market is clearly not constant over time.
Based upon a casual analysis it appears that a major factor influencing
market liquidity is the general market environment. Specifically, liquidity
was low during the 1969-70 bear market and also declined steadily during
1973-74 when stock prices fell by over 40 percent. In fact, the series hit
its trough during 1974. In contrast, market liquidity reached its high
point during the bull market of 1972, and increased from its low point during
the rising market of 1975.
The results for the Amivest Share Index (Exhibit 2) are quite similar.
In this case the range was from about .08 (80,000 shares) in 1970 and 1974,
to a high of over .60 (600,000 shares) during 1972. This similarity in wide
ranges is not surprising since the monthly values for the two liquidity
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EXKIBIT 1
TIME SERIES PLOT OF MONTHLY AMIVEST DOLLAR LIQUIDITY
INDEX FOR NEW YORK STOCK EXCHANGE
January, 1969 - December, 1975
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1970
1971 1972 1973
Time
1974
1975
1976
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EXHIBIT 2
TIME SERIES PLOT OF MONTHLY AMIVEST SHARE LIQUIDITY
INDEX FOR THE NEW YORK STOCK EXCHANGE
January, 1969 - December, 1975
--L-L-_l_4__L_l__L
1971
1972 1973 1974
Time
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series are correlated about .90.
In suncnary, these graphs indicate that aggregate market liquidity varies
widely over time and is quite volatile on a month-to-month basis.
INDIVIDUAL STOCK LIQUIDITY
Measures for Individual Stocks
As noted, the A.v.ivest measures can be derived for individual stocks
for a period of tine. Obviously the computations are much more extensive
because total dollar trading and share trading is not available for indivi-
dual stocks. Therefore it is necessary to determine daily percent price
changes for each stock relative to the volune of trading for each day. The
share volume is straightforward; the dollar volunie was computed as the num-
ber of shares traded times the mean of the high and low price for the day.
A r— :!";":? 7 figure is computed as follows:
N
. . ^ ex T J T* Shares Traded Day i .,
Amivsst Share Index = E ^ ^ -, . -=r ^-7 — jr^; — N
... Percent Price Change w/o Sign
A„.v..... n-^^^„.. T-,-v_ „ yy Shares Traded x (HifLo/2) j,
. , Percent Price Change w/o Sign
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where N = the nunber of tradirj days in the month.
Because of the extensive computations required for each stock, it is
not feasible to derive the index for each stock for every month during the
time period. Beccuse we v.'anted to analyze '':hese series for individual
stocks over time, it wac docided to compute the measure for a specified
month each year. Specifically, it v-.s decided to compute the measure
during the month of May for each year 1959-1975. The choice of May was
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arbitrary on the basis that stock prices should not be affected by year-end
factors that occur during November to February or influenced by the "summer"
rally factors.
An analysis of the liquidity indexes indicated that the liquidity values
vary substantially among stocks, and also vary for individual stocks over
time. One obvious reason for expecting the liquidity values for individual
stocks to vary over time is that the aggregate market liquidity varies sub-
stantially. Therefore, it was decided to "normalize" the monthly liquidity
value for individual stocks by the aggregate market value for that month.
The result is a relative measure of liquidity over time as follows:
_,^. .. ^nii Tj Co. Ami vest Dollar Index (May)
Relative Amivest Dollar Index = t-. — ■, — ^ . . ^ - ,, ^ j ri, ^
Market Amivest Dollar Index (May)
As an example, the unadjusted dollar index for American Can during
May, 1969, was $958,497 and the comparable market index was $1,706,557.
Therefore, the relative dollar Amivest index for American Can was .562,
indicating that American Can's dollar liquidity during May, 1969, was about
56 percent as large as the average stock on the NYSE, A comparable calcu-
lation with American Can's share index and the market share index shows a
relative share value of .51 indicating that American Can's share liquidity
was about one-half as large as the share liquidity for the average stock
on the NYSE.
The relative liquidity measures for individual stocks are employed in
the next section where there is a comparison of the market liquidity for a
sample of larger firms to the liquidity for a sample of smaller firms.
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LARGER FIRMS VERSUS SflALLER FIRMS
Sample Firms
The total sample was derived as part of a larger study that considered
external and internal liquidity using quarterly financial statements.
Therefore, the larger firm sample includes 24 firms that provided quarterly
financial statements (balance sheet and income statements) for the seven
years 1969- 197S. The companies also had to be on Corapustat and on the
University of Chicago stock price tapes (CRSP tapes) . Even with these con-
straints, the list includes the three largest industrial firms on the
Fortune 1975 top 1000 industrial list (Exxon, General Motors, and Ford).
There were only five companies that would not be in the top 100 (United
Airlines was second on the transportation list but would have been about
number 75 on the industrial list; Jewel Companies were 11th on the retailing
list and would have been 80 on the industrial list). The smallest company
in this sample was Amsted with a rank of 360. The sample of smaller firms
was randomly selected from the 50 smallest firms on the Fortune 1000 list
that likewise had data available on Compustat and CRSP.
Clearly the sample of larger firms is generally the largest available
in our economy since they are near the top of the Fortune list. In con-
trast, the sample of "smaller" firms are not small in absolute terms since
they are still part of the Fortune list, but are definitely smaller than
the large group. As an example, the 1,000th company on the 1975 Fortune
list was Seagrave. This company had sales of over $91 million and assets
of over $57 million. In absolute terms this firm is not small, but it is
small compared to Exxon (number 1 in 1975) that had sales of $42 billion
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and assets of $31 billion. The point is, the smaller company sample is
small compared to the larger firms, but still much larger than a number of
other public firms which number close to 10,000. Therefore, they are smaller
than the large firms, but larger than about 9,000 other firms.
Overall Individual Stock Results
An examination of the liquidity values for the two samples in Exhibits
3 and 4 indicates three relevant observations. First, the relative values
vary widely between individual firms within a group (larger firms or smaller
firms) even though the firms in a sample are quite comparable in terms of
company size as shown in the Fortune list. As an example, during 1969 the
relative dollar indexes for the large firm sample ranged from .07 for Amsted
to 7.14 for Atlantic Richfield. If one ignores Amsted as being too small,
the low value becomes .35 and the high to low ratio is over 20 times.
The second observation is that the liquidity values for individual
stocks vary substantially over time. This is impressive considering that
these are relative measures and as such should not be affected by market
changes. As an example, the Eastman Kodak relative dollar index ranged
from 1.94 in 1969 to 30.92 in 1973--a factor of over 15. Finally, it is
apparent that the relative dollar indexes and relative share indexes for
individual companies during specific years are generally quite similar.
Put another way, the alternative liquidity measures for individual stocks
clearly move together over time.
Comparisons
The purpose of the subsequent comparisons is twofold. The first intent
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is to detsrrnine if there are aij differences in the level of -arket liquidity
for small versus large firms. Tlie second purpose is to determine if there
-has been any difference in the trends of liquidity over time. Specifically,
have the liquidity values for larje and smaller firms moved in parallel
ever tiT.o or has there beon a change in the performance of one group rela-
tive to tho other?
Regp.rdr.r.g tho differential level of liquidity it v;as expected that en
aver:;;;;:- '.1:0 lar^o fii:r:3 v.ould h'^ve a higher level of liquidity than the
cir^ller firr.s becauce ifty have more shares outstanding, they are better-
kncvm, and g3nerally e^qperience more trading activity. Tlie expectation
for the analysis cf differential tr'. Is is related to the notion of a
tiered i;;--:i;£t. It has been observed diiring the past ten years that because
of t'le gr':-v;th of institutions and the increase in their trading turnover,
•^.!•x•7 have cc:7i3 to dominate trading in the secondary equity mar/.et [1, I[.
r-.irther, ij-stituticns prefer large fir:?.3 because of their liquidity [8].
Hence, a "tiersJ r.avlce':" has evolver' -.•Ath ie.rge firms in the upper tier
ar.u the great tnl.k cf cr.aller firjis comprising the lower tier [5, 10]. The
result of tr.e tiered carket in terms of liquldi-^.y is that the rich get
richer and the peer i^ct poorer. Specifically, one v-ouid ej'p.'ct in a tiered
Earl'.et that the largs fir.7.i tl.at are of intorost to the ir.stitutirns that
c!crrln?.te trading v;culd bec.?.-^e rr.ore liquid, vhile the mailer firr'.s in the
lovjer tirr v:ould cithet' szi^orier.ce t.o c!:a:'g3 in liq.iidity or might even
show a dealir.o in '-heir rarkct liquidity over tiirio. Tiercfore, it was
hypothesized t'lat there v.'culd bo a divergence in the liquidity for the
two groups -"ver tir.e.
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Differences in the Level of Liquidity
The analysis considered the average liquidity for the two samples of
stocks over tiir.3. The results reported in Exhibit 5 clearly support the
belief that there is a majcr diffcrsnos in the relative liquidity for the
large firms compared to the smaller firms. In fact, the differences were
substantially larger than expected. In terns of the relative dollar li-
quidity ir.easurcs, the larje fir.-:: ere over 50 tines more liquid than the
smaller firns. In teri:-.s of the relative shcre liquidity measures the
large firir.G are over 15 timoj mors liquid.
Tne difference in cc:rparicG.. for the tv.'o measures is interesting.
This difference occurs because the dollar index for the larger firms is
generally tv;ice as Inr^e as the shpre index for these firms. "'':: contrast,
for the ST.aller firr.s S.-^ chj.ro indc:: is Ic.rz":^ than the dollar index.
Tliis seening parade:: ca::. be e.iplr'J.ned by the differential price of the
share.'^ for the twe rets of firns. 'ilie average share price for the large
firms is in exce£:3 of $r>0, v/hile the average share price fcr the smaller
"irms is about $25. Tliersfore, the large f .' ;:x? have greater share liquidity,
i.e., they czn sell about 15 time- more shares fcr a given percent ch-'-nge
in price than the smaller firms. Then, considering the price of the s
shares for the larger firrv' is about twice the share price of the small
firr.s, the dollar values indicate an investor in a large firm can buy or
sell 30 times cs rany dollars of stock for a given percent change in price
as an investor in a £:r'T.ll?r fir:?..
Because of the possible price bias connected with the share index,
most observers would probably agree that the dollar index is preferable
for cor^paring tv;o groups cf stocko. The point is, ^ri'S-rt-^J.'.' 3 of which
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EXHIBIT 5
AVERAGE RELATIVE LIQUIDITY VALUES
FOR LARGE AND SELLER Vim SAMPLES
Dollar Index
1969
1.705
.050
34.1
1970
4.715
.107
44.1
1971
1.709
.061
28.0
1972
2.455
.097
25.3
1973
6.796
.105
64.7
1974
4.463
.101
44.2
1975
3.409
1 .103
33.1
Share Index
Ratio
Large
Small
L/S
1.236
.081
15.3
3.256
.173
18.8
1.259
.089
14.1
1.454
.116
12.5
3.359
.144
23.3
2.175
.127
17.1
1.756
.116
15.1
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the average dollar index for large firms went from 1.705 in 1969 to a
high of 6.796 in 1973 and ended in 1975 at 3.409--double the 1969 value.
Similarly, the average dollar index for the small firms went from .05 in
1969 to about .10 in 1975. Notably, the relative measures for both samples
were high during 1973 and 1974 which were periods of declining stock prices
and generally low market liquidity as shown earlier. The relative measures
for these two samples increased because the liquidity for both groups of
firms likewise declined, but the decline was not as severe as for the
aggregate market. Notably, the relative performance by the larger firms
during this period of declining stock prices was superior to the perfor-
mance by smaller firms.
Ratio Over Time
The performance of the large to small liquidity ratio over time was
not consistent with expectations based upon the development of a tiered
market. The time series plot shown in Exhibit 6 indicates that the ratio
of the average relative liquidity measures varied over time and ended the
period slightly lower than at the beginning of the period. Notably,
this ratio declined during 1971 and 1972, and increased during 1973 and
1974. This would indicate that the differential between large and smaller
firms varied by market period. Specifically, during rising markets such
as 1971 and 1972 the relative liquidity for the smaller firms increased
more than for the larger firms. In contrast, during declining markets,
the market liquidity for smaller firms declines much more than that for
larger firms.
Although the average relative liquidity data do not support the
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but the larger company results are more consistent and the larger
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is of greatest importance.
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REFERENCES
[1] "Are the Institutions Wrecking Wall Street?" Business Week (June 2,
1973).
[2] Hirsch, Michael D. , "Liquidity Filters: Tools for Better Performance,"
Journal of Portfolio Management , Vol. 2, No. 1 (Fall, 1975), pp. 46-50.
[3] Klemkosky, Robert C, "Institutional Dominance of the NYSE," Financial
Executive , Vol. 41, No. 11 (November, 1973), pp. 14-20.
[4] Laing, Jonathon R. , "Fiduciary Grants: Huge Sums Managed by Bank Trust
Units Stirs Up Controversy," Wall Street Journal (January 7, 1975).
[5] Loomis, Carol J., "How the Terrible Two-Tier Market Came to Wall Street,"
Fortune (July, 1973).
[6] Lyons, John F., "IVhat Happens When Liquidity Disappears?" Institutional
Investor , Vol. 3, No. 11 (November, 1969), pp. 29-36, 98.
[7] McClintick, David, "Illiquid Stocks--Lack of Ready Buyers and Sellers
Imperils the Stock Market," Wall Street Journal (December 10, 1971).
[8] Reilly, Frank K. , "A Three Tier Stock Market and Coiporate Financing,"
Financial Management , Vol. 4, No. 3 (Autumn, 1975), pp. 7-15.
[9] Reilly, Frank K. and Wright, David, "An Analysis of Aggregate Stock
Market Liquidity," Paper presented at the Eastern Finance Association
Meeting, Boston, Mass. (April, 1977).
[10] Wood, C. v., Jr., "Why It's Hard to Raise Capital Today," Financial
Executive , Vol. 41, No. 11 (November, 1973), pp. 21-28.
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