Business Condition Expectations and Stock Return Predictability: International Evidence

Abstract

We construct a one-month-ahead conditional expectation measure of global business conditions relying on lagged OECD composite leading indices, and demonstrate that this index is a powerful predictor for aggregate stock returns around the globe, both in- and out-of-sample. We indicate that leading economic variables are valuable in capturing one-month-ahead conditional expectations when their lead time over actual economic activity is known. Moreover, the predictive power of the index at one-month return horizon stems from capturing business condition expectations for the future one-month. The predictability weakens as the forecast horizon for business condition expectations deviates further from the future one-month. Furthermore, we show that the index affects stock returns through the cash flow channel, and provides incremental forecasting information beyond local idiosyncratic business conditions and other economic and financial forces.

Keywords: Global business condition expectation, International stock markets, Return predictability, Out-of-sample forecast

JEL Classification: G12, G15