The Relation Between Aggregate Stock Illiquidity and Expected Excess Market Returns

Previous studies provide elusive evidence that aggregate stock illiquidity predicts excess market returns. We revisit this issue using transaction-level data over the 1984 to 2007 period to construct more precise illiquidity measures. Illiquidity alone has negligible forecasting power; however, its correlation with future market returns becomes significantly positive when in conjunction with other risk factors. Results are similar albeit weaker for less precise illiquidity measures constructed from daily data (as used in the previous studies). We document similar evidence for the long sample period 1927 to 2007, over which only low-frequency illiquidity measures are available. Moreover, the commonly used stock return predictors do not account for the forecasting power of market-wide illiquidity. Our results suggest that illiquidity risk is an important determinant of the conditional equity premium.