48 Pages Posted: 13 Sep 2002
Date Written: May 23, 2002
I assemble an annual time series of bid-ask spreads on Dow Jones stocks from 1900-2000, along with an annual estimate of the weighted-average commission rate for trading NYSE stocks since 1925. Spreads are cyclical, especially during periods of market turmoil. The sum of half-spreads and one-way commissions, multiplied by annual turnover, is an estimate of the annual proportional cost of aggregate equity trading. This cost drives a wedge between aggregate gross equity returns and net equity returns. This wedge can account for only a small part of the observed equity premium, but all else equal the gross equity premium is perhaps 1% lower today than it was early in the 1900's. Finally, I present evidence that the transaction cost measures that also proxy for liquidity - spreads and turnover - predict stock returns one year or more ahead. High spreads predict high stock returns; high turnover predicts low stock returns. These liquidity variables dominate traditional predictor variables, such as the dividend yield. The evidence suggests that time-series variation in aggregate liquidity is an important determinant of conditional expected stock market returns.
Keywords: transaction costs, bid-ask spreads, time-varying expected returns, return predictability, systematic liquidity
JEL Classification: G12, G14, N21, N22
Suggested Citation: Suggested Citation
By Meb Faber
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