Illiquidity and Earnings Predictability

This paper studies the relation between illiquidity and the predictability of fundamental valuation variables. Theory suggests that illiquidity increases during periods of uncertainty about stock value. Consistent with this prediction, we document that during illiquid periods aggregate stock returns contain less information about future aggregate earnings, GNP growth, and industrial production. In addition, a firm-level cross-sectional analysis shows that returns of illiquid stocks contain less information about their future firm earnings compared to those of more liquid stocks. Finally, we document that analyst-forecast error and analyst-forecast dispersion are higher for more illiquid stocks. The results provide further evidence for the impact of illiquidity on fundamental value.