Academic journal article Federal Reserve Bank of St. Louis Review

Why Are Stock Market Returns Correlated with Future Economic Activities?

Academic journal article Federal Reserve Bank of St. Louis Review

Why Are Stock Market Returns Correlated with Future Economic Activities?

Article excerpt

Stock price has been found to provide important in formation about future economic activities. Fama (1981), Fischer and Merton (1984), and Barro (1990), among many others, document a positive relation between stock market return and subsequent growth in investment and output. These findings are consistent with rational expectations asset pricing models, in which stock price is equal to the sum of discounted future cash flows or dividends. An unexpected increase in the stock price indicates that (i) future dividend growth is higher and/or (ii) future discount rates are lower than previously anticipated. Given that the dividend is an important component of gross domestic product (GDP) and is also likely to be positively correlated with the other components of GDP, the stock price increase may merely reflect higher expected future output. On the other hand, lower discount rates are associated with higher investment and, therefore, higher output. (1) Moreover, recognizing a time-varying risk premium, Lettau and L udvigson (2001b) show that the q theory of investment implies an important relation between the expected stock market return and investment. That is, lower expected stock market return implies lower future stock price and higher future capital cost; accordingly, investment falls over long horizons.

The analysis above shows that stock returns are correlated with future economic activities through different channels. In this paper, I address the relative importance of these mechanisms by using Campbell and Shiller's (1988) method to decompose excess stock market return, [e.sub.M,t], into three parts: expected return, [E.sub.t-1][e.sub.m,t]; a shock to the expected future return.

-([E.sub.t] - [E.sub.t-1])[summation over ([infinity]/j=1)] [[rho].sup.j][e.sub.M,t+j];

and a shock to the expected future dividend growth, (2)

([E.sub.t] - [E.sub.t-1])[summation over ([infinity]/j=0)] [[rho].sup.j][DELTA][d.sub.M,t+j].

I find that a positive shock to the expected future dividend growth is associated with higher future GDP growth. Contrary to the conventional wisdom, however, dividend shocks are rather weak predictors for economic activities. For example, their forecasting power concentrates on the next four quarters, of which dividend shocks explain only about 2 percent of variations in GDP growth. I find similar results for the GDP components as well. In contrast, the expected return, especially, and shocks to the expected future return exhibit strong predictive ability for economic activities. However, their predictive patterns are quite different: while shocks to the expected future return are positively (negatively) correlated with future investment over short (long) horizons, the expected return is negatively (positively) correlated with future investment over short (long) horizons. As a result, the forecasting power of excess stock market return is considerably compromised. For example, it explains essentially no vari ations in one-quarter-ahead investment growth, while the three components jointly account for 4 percent. Also, excess stock market return explains only 2 percent of variations in the next three years investment growth, compared with 13 percent by the three components.

Intuitively, a positive innovation in the dividend indicates greater future economic growth. However, the forecasting power of dividend shocks is moderate because my decompositions show that they account for only a small portion of variations in excess stock market return. The relation between the expected return, [E.sub.t-1] [e.sub.M,t], and future investment is consistent with Lettau and Ludvigson (2001b), who show that the two variables are negatively correlated in the short run and are positively correlated in the long run. Similarly, because the shock to the expected future return at period t,

-([E.sub.t]-[E.sub.t-1]) [summation over ([infinity]/j=1)] [[rho].sup.j][e.sub. …

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