What Can Markets Tell Us about Future Economic Growth? Historical Predictive Power of the Bond, Stock and Real Estate Markets

Abstract

Do bond, stock and real estate markets provide useful signals for forecasting future GDP? Using market data since 1970, we examine several market signals and find that, in general, they have not been very helpful in predicting next year’s GDP, or the change in next year’s GDP versus last year. If we fit the market signals to the full data period, the signals explained 48% of the variation in next year’s GDP and 44% of the variation in the change of next year’s GDP. However, what matters more to investors is the predictive power of market signals. In terms of prediction, where only contemporaneous market signals are used to form forecasts, the predictive power of market signals has been poor. Relative to other market signals, the Treasury yield curve slope, stock market returns and the change in CAPE have exhibited better predictive power. However, even their absolute predictive power has been relatively low, and this power has fluctuated over time. To improve the predictive power of market signals, we explore combining many signals, and selecting them dynamically. Nevertheless, the average prediction error (RMSE) for next year’s annual GDP was 2.05 (in annual GDP percentage points), and 2.45 for the GDP change.