Has the U.S. Stock Market Become More Vulnerable over Time?

This study demonstrates that the cross-sectional variation of systematic risk and systematic liquidity has increased from 1963 to 2008. Both have increased significantly for large-capitalization companies but have declined significantly for small-cap companies. These findings have several implications for investment managers, including the declining ability to diversify return volatilities and liquidity shocks by holding liquid, large-cap stocks. The findings suggest that the vulnerability of the U.S. equity market to unanticipated events has increased over the past few decades.This article concerns the evolution of systematic risk and systematic liquidity in a cross-section of U.S. stocks from 1963 to 2008 and the implications for the vulnerability of the U.S. stock market to marketwide liquidity and return shocks. For our sample period of 1963−2008, we found that both systematic risk and systematic liquidity (which we defined as the sensitivity of a stock’s return and liquidity to market return and liquidity, respectively) have decreased significantly for small-capitalization companies but have increased significantly for large-cap companies. We showed that these cross-sectional divergence patterns are associated with each other.The increased cross-sectional divergence of systematic risk and systematic liquidity has important implications for the ability to diversify return volatility and liquidity shocks among companies. We found that the ability to diversify return and liquidity shocks by holding relatively liquid large-cap stocks has declined from 1963 to 2008, both in absolute terms and relative to the diversification benefits of small-cap stocks. Thus, the ability to diversify return volatility and liquidity shocks by holding an otherwise well-diversified, value-weighted portfolio has declined over time. In contrast, we found that the ability to diversify risk and liquidity shocks by holding shares of small companies has improved over time. This finding is particularly noteworthy because of the “flight to quality” from small-cap stocks to large-cap stocks in turbulent times. Our findings, therefore, suggest that the vulnerability of the U.S. equity market to unanticipated events has increased from 1963 to 2008.We conjectured that the trends of increased systematic risk and systematic liquidity can be explained by the growth in institutional ownership from 1963 to 2008. We had previously found that the sensitivity of the stock’s liquidity to aggregate liquidity shocks increases with institutional ownership, and institutional investing and index trading have been more concentrated in large-cap stocks than in small-cap stocks. Index and basket trading, both increasingly popular with institutional investors, can affect systematic liquidity via correlated trading patterns that affect the liquidity of many stocks. Moreover, because trading activity and order flows affect stock prices, correlated trading among many stocks can also affect the co-movement of daily stock returns.Our findings have several important implications for investment managers. We showed that because of the increased systematic risk of large companies, building a large-cap index fund has become easier—that is, one can achieve low tracking error, relative to a large-cap index, by using fewer stocks. Moreover, the benefits of diversifying among large-cap stocks when constructing a value-spread portfolio (high-book-to-market stocks minus low-book-to-market stocks) have declined over time; the volatility of the value-spread portfolio constructed with small-cap stocks has declined relative to such a portfolio with large-cap stocks.