Recent theories of state-dependent variations in market liquidity suggest strong variations in expected illiquidity premium across economic states. Adopting a two-state Markov switching model, we find that while illiquid stocks are more strongly affected by economic conditions than liquid ones during recessions, the differences in expected returns are relatively weak during expansions. As a result, the expected illiquidity premium displays strong state-dependent variations, and its countercyclical pattern is consistent with theoretical argument based on timevarying liquidity risk premium. Overall, our results provide a strong relation between the expected illiquidity premium and the real business cycle.