On the 'Great Disconnect' between Stock Returns and GDP Growth Forecast Errors: Implications for Interdisciplinary Capital Markets Research in Accounting

Abstract

Using consensus forecasts from the Philadelphia Fed’s Survey of Professional Forecasters, I find that the univariate association between stock returns and GDP growth forecast surprises is indistinguishable from zero. I consider two non-mutually exclusive hypotheses for this phenomenon. The first hypothesis is that GDP growth forecast surprises are correlated with offsetting cash flow news and discount rate news. The second hypothesis is that GDP growth forecast surprises measure news about economic growth with noise. Using Easton’s et al. (2002) implied cost of capital procedure along with Li and Mohanram’s (2014) cross-sectional earnings forecasts, I extract a measure of discount rate news at the stock market level and find evidence consistent with the first hypothesis. A key implication is that researchers interested in the valuation of news about economic growth need to account for the impact of contemporaneous movements in the discount rate. From an implementation standpoint, my study shows that changes in implied cost of capital estimates offer a comprehensive measure of discount rate news capturing not only procyclical variation in the long-term nominal interest rate but also countercyclical variation in the otherwise unobservable equity risk premium.