A Century of Stock Market Liquidity and Trading Costs

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 halfspreads 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 1900s. 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.