Unemployment and aggregate stock returns

Abstract

This paper presents new evidence on the predictability of aggregate stock market returns by a labor market based economic indicator–the unemployment gap–which is defined as the difference between the actual unemployment rate and its estimated trend. The unemployment gap emerges as a strong predictor of both raw stock returns and excess stock returns, in the U.S. and in international data. In addition, fluctuations in the unemployment gap are tightly linked to cyclical variation in risk preferences. A widening of the unemployment gap, i.e. a rise in the unemployment rate relative to its trend, is associated with a rise in risk aversion and higher excess returns. The results support the view that the expected equity risk premiums arise as a rational response of economic agents to changes in the investment opportunities.