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Micro(structure) before Macro? The Predictive Power of Aggregate Illiquidity for Stock Returns and Economic Activity

91 Pages Posted: 2 Nov 2014 Last revised: 29 Apr 2017

Yong Chen

Texas A&M University - Department of Finance

Gregory W. Eaton

Oklahoma State University - Stillwater - Department of Finance

Bradley S. Paye

Virginia Polytechnic Institute & State University - Department of Finance, Insurance, and Business Law

Date Written: April 26, 2017

Abstract

This paper constructs and analyzes various measures of trading costs in US equity markets covering the period 1926–2015. These measures contain statistically and economically significant predictive signals for stock market returns and real economic activity. We decompose illiquidity proxies into a component capturing aggregate volatility and a residual. The predictive content of these components differs in important ways. Specifically, we find strong evidence that the component of illiquidity uncorrelated with volatility forecasts stock market returns. Both the volatility and residual components of illiquidity contain information regarding future economic activity.

Keywords: Stock market liquidity, stock return predictability, macroeconomic forecasts, transactions costs, equity premium

JEL Classification: G1, C13

Suggested Citation

Chen, Yong and Eaton, Gregory W. and Paye, Bradley S., Micro(structure) before Macro? The Predictive Power of Aggregate Illiquidity for Stock Returns and Economic Activity (April 26, 2017). Journal of Financial Economics (JFE), Forthcoming. Available at SSRN: https://ssrn.com/abstract=2517812 or http://dx.doi.org/10.2139/ssrn.2517812

Yong Chen

Texas A&M University - Department of Finance ( email )

360 Wehner Building
College Station, TX 77843-4218
United States

Gregory W. Eaton

Oklahoma State University - Stillwater - Department of Finance ( email )

Spears School of Business
Stillwater, OK 74078-4011
United States

Bradley S. Paye (Contact Author)

Virginia Polytechnic Institute & State University - Department of Finance, Insurance, and Business Law ( email )

1016 Pamplin Hall (0221)
Blacksburg, VA 24060-0221
United States

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