Market Illiquidity and Conditional Equity Premium

We examine the time-series relation between aggregate bid-ask spreads and conditional equity premium. We document that average marketwide relative effective bid-ask spreads forecast aggregate market returns only when controlling for average idiosyncratic variance. This control allows us to document the otherwise elusive relation between illiquidity and returns. The reason is that idiosyncratic variance correlates positively with spreads but has a negative effect on conditional equity premium, causing an omitted variable bias. Our results are robust to standard return predictors, alternative illiquidity measures, and out-of-sample tests. These findings are important because they provide strong support for the literature's conjecture that marketwide liquidity is an important asset pricing risk factor.