Cross-Sectional PEG Ratios, Market Equity Premium, and Macroeconomic Activity

Abstract

This paper exploits information contained in cross-sectional PEG ratios to extract estimates of the market's expectations for aggregate returns and economic fundamentals. By combining the loglinear present-valuation model and the Capital Asset Pricing Model (CAPM) logic, we establish a theoretic link between PEG ratios and expected returns of stocks. Using this theoretic link, we construct one proxy for aggregate market equity premium and one proxy for macroeconomic fundamentals. The equity premium proxy outperforms alternative predictors and has considerable power in forecasting future market returns over the period of May 1983 to December 2009. The equity premium proxy is also able to forecast future macroeconomic activity such as nonfarm payroll growth, personal consumption expenditure growth, nondurable consumption growth, inflation, and unemployment rate. The fundamentals proxy is highly correlated with unemployment rates both concurrently and intertemporally. The results are generally robust across subsample and to various econometric methods for standard-error adjustments. Our study suggests that the choice of cross-section data is critical to information extraction and that the CAPM remains a vital theoretic tool to guide empirical work.