#05-26
Stock Returns and Expected Business Conditions:Half a Century of Direct Evidence
Sean D. Campbell and Francis X. Diebold
Abstract: We explore the macro/finance interface in the context of equity markets. In particular,
using half a century of Livingston expected business conditions data we characterize directly the
impact of expected business conditions on expected excess stock returns. Expected business
conditions consistently affect expected excess returns in a statistically and economically
significant counter-cyclical fashion: depressed expected business conditions are associated with
high expected excess returns. Moreover, inclusion of expected business conditions in otherwise standard
predictive return regressions substantially reduces the explanatory power of the
conventional financial predictors, including the dividend yield, default premium, and term
premium, while simultaneously increasing . Expected business conditions retain predictive
power even after controlling for an important and recently introduced non-financial predictor,
the generalized consumption/wealth ratio, which accords with the view that expected business
conditions play a role in asset pricing different from and complementary to that of the
consumption/wealth ratio. We argue that time-varying expected business conditions likely
capture time-varying risk, while time-varying consumption/wealth may capture time-varying risk
aversion.
Keywords: Business cycle, expected equity returns, prediction, Livingston survey, risk aversion, equity premium, risk premium
JEL classifications : G12
