Davids, Goliaths, and Business Cycles
We show that a simple, intuitive variable, GVD (Goliath versus David) reflects time-variation in discount rates related to changes in aggregate business conditions. GVD is the annual change in the weight of the largest 250 firms in the aggregate stock market, and is motivated by research that shows that small firms are more severely impacted than large firms by economic shocks due to differences in access to external finance. We find that GVD is the best single predictor of market returns out-of-sample among traditional predictors, predicting quarterly market returns with an out-of-sample R2 of 6.3% in the 1976-2011 evaluation period. Consistent with its motivation, GVD forecasts lower future GDP and aggregate investment growth. GVD also forecasts returns on treasury bonds and the 25 size and book-to-market sorted portfolios (and consequently HML as well as SMB), with assets we ex-ante expect to be more sensitive to discount rate variation displaying greater sensitivity to GVD. We show that GVD is the only variable among traditional predictors that forecasts stock returns, bond returns, and macroeconomic variables. We also show that GVD's predictive ability is robust, and not due to information contained in traditional variables, such as SMB and net payout.
Number of Pages in PDF File: 49
Keywords: Business cycles, forecasting, market returns
JEL Classification: G11, G12working papers series
Date posted: October 3, 2012 ; Last revised: April 17, 2013
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