Does the stock market predict real activity? Time series evidence from the G-7 countries

Abstract

This paper extends one aspect of the US stock market study of Fama (1990) and Schwert (1990). We examine the relationship between industrial production (IP) growth rates and lagged real stock returns for the G-7 countries using both in-sample cointegration and error-correction models and the out-of-sample forecast-evaluation procedure of Ashley et al. (1980). The cointegration tests show a long-run equilibrium relationship between the log levels of IP and real stock prices, while the error-correction models indicate a correlation between IP growth and lagged real stock returns for all countries except Italy. The out-of-sample tests show that in several sub-periods the US, UK, Japanese, and Canadian stock markets enhance predictions of future IP.