Does the Stock Market Predict Macro-Variables?

Abstract

Movements in the stock market should reflect expectations regarding future economic conditions and lead the macroeconomy. However, evidence for stock returns providing such predictive power is mixed. We argue this arises as stock returns are noisy and consider the predictive ability of derived expected returns, as well as, the price-earnings ratio, VIX and the stock/bond return correlation. Results reveal that expected stock returns and the stock/bond return correlation exhibit predictive power for output and consumption growth and inflation at monthly and quarterly frequencies. The VIX has predictive power at the monthly frequency for consumption growth and inflation, while the price-earnings ratio predicts the shape of the future term structure. Results reveal that higher current expected returns are consistent with to higher future output and consumption growth, while greater risk results in lower future economic activity. The results are robust to considerations of structural breaks and alternative variables. Further, expected returns provides a noticeably more accurate recession prediction than realised returns. Thus, while stock returns are a weak predictor, expected returns and alternative proxies for stock market risk do reveal predictive power. Such information provides a leading role indicator for the macroeconomy and reveals links between financial markets and the economy.