Sinking Ships: Illiquidity and the Predictability of Returns on Real Assets in Recessions

Using the context of the dry-bulk shipping industry, I document that future returns on real assets are strongly predictable and negatively related to current asset prices, earnings, and investment during recessions. However, there is no such relationship outside recessions. This asymmetry points against existing explanations of return predictability, such as predictable boom-bust cycles arising from firms overreacting in good times. Instead, I argue that predictability arises in recessions due to liquidity constraints and limits to arbitrage. When cash flows evaporate, distressed firms are forced to sell assets to their liquidity-constrained peers, resulting in falling prices and rising expected returns for buyers. This theory is corroborated by narratives from industry practitioners and dynamics of forced auction sales. Considering that shipping is virtually a model case of a competitive industry operating large and expensive assets, the results likely generalise to other capital-intensive sectors of the economy.