A Century of Stock Market Liquidity and Trading Costs

ABSTRACT I assemble and examine an annual time series of bid–ask spreads on Dow Jones stocks from 1900 to 2000 and average commission rates 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, estimates the aggregate cost of trading and drives a wedge between gross and net equity returns. This difference explains only a small part of the observed equity premium, though I show that the gross equity premium is perhaps 1% lower today than it was early in the 1900's. Finally, I find that the transaction cost measures (spreads and turnover), which serve as a proxy for liquidity, predict stock returns 1 year or more ahead and dominate traditional measures such as the dividend yield. The evidence suggests aggregate liquidity is a determinant of expected stock market returns.