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.
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.
Theoretical literature suggests that empirical measures of aggregate illiquidity should contain predictive signals for future stock returns and economic activity. We construct a variety of measures of market frictions at monthly and quarterly frequencies using daily CRSP data for stocks listed on the New York Stock Exchange (NYSE).3 These time series cover a 90 year period from 1926–2015 and include multiple proxies for the effective spread, several alternative measures of price impact, and a measure of aggregate price delay. Since our measures relate positively to transaction costs, we refer to them as “illiquidity” measures.
We use principal component analysis on 55 bilateral exchange rates of 11 developed currencies to identify two important global risk sources in FX markets. The risk sources are related to Carry and Dollar but are not spanned by these factors. We estimate the market prices associated with the two risk sources in the cross-section of FX market returns and construct FX market implied country-specific SDFs. The SDF volatilities are related to interest rates and expected carry trade returns in the cross-section. The SDFs price international stock returns and are related to important financial stress indicators and macroeconomic fundamentals.
The first principal risk is associated with the TED spread, quantities measuring volatility, tail and contagion risks and future economic growth. It earns a relatively small implied Sharpe ratio. The second principal risk is associated with the default and term spreads and quantities capturing volatility and illiquidity risks. It further correlates with future changes in the long term interest rate and earns a large implied Sharpe ratio.