Davids, Goliaths, and Business Cycles

Abstract

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.

Keywords: Business cycles, financial constraints, market returns, investment growth

JEL Classification: E44, G12