RFS Advance Access originally published online on October 2, 2008
Review of Financial Studies 2009 22(7):2801-2833; doi:10.1093/rfs/hhn087
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Time-Varying Risk Premiums and the Output Gap
University of Haifa and Norwegian School of Management
Send correspondence to Richard Priestley, Norwegian School of Management, Nydalsveien 37, N-0444 Oslo, Norway; telephone: +47 46 410 515; fax: +47 23 264 723. E-mail: richard.priestley{at}bi.no.
JEL Classification: E44, G12, G14
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Abstract |
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The output gap, a production-based macroeconomic variable, is a strong predictor of U.S. stock returns. It is a prime business cycle indicator that does not include the level of market prices, thus removing any suspicion that returns are forecastable due to a "fad" in prices being washed away. The output gap forecasts returns both in-sample and out-of-sample, and it is robust to a host of checks. We show that the output gap also has predictive power for excess stock returns in other G7 countries and U.S. excess bond returns.
We would like to thank an anonymous referee, Mathew Spiegel (the Editor), Ravi Bansal, Kobi Boudoukh, Ian Garrett, Vito Gala, Francisco Gomes, Urban Jermann, Eric Jondeau, Boyan Jovanovic, Leonid Kogan, Jonathan Lewellen, Sydney Ludvigson, Thomas Philippon, Kjetil Storesletten, Raman Uppal, Annette Vissing-Jørgensen, and seminar participants at the AFA Meeting 2006, Econometric Society World Congress 2005, EFA Meeting 2007, University of Bath, University of Haifa, Hebrew University, HEC Lausanne, and University of Oslo for helpful comments and suggestions. We also thank John Cochrane, Michael Roberts, and Jeffrey Wurgler for making their data available to us. We express our gratitude to Todd Clark for generously providing his code that calculates the out-of-sample forecasting tests.