The Book of Genesis warns that seven fat years in Egypt will be followed by seven years of famine-civilization's original macroeconomic forecast.
Economists have learned a thing or two in the millennia that followed, but the case for recognizing the influence of cycles is as persuasive as ever. Connecting all the dots between macroeconomics and finance doesn't follow a straight path, yet most investors recognize that the economy and the capital markets are linked. Otherwise, you might as well say that sunspots or the phases of the moon are calling the shots. We either live in an economically logical world, or we don't. It appears that we do, as the mounting body of evidence suggests. That includes research telling us the economy is the crucial driver of the equity risk premium.
Ultimately, all analytical roads lead back to the economy, although the connection between stocks and GDP growth isn't necessarily intuitive or one-dimensional. Nor does it tell us everything we need to know about projecting stock market returns. Nonetheless, the union is quite sturdy, even if it's not always obvious. As Jeremy Siegel writes in Stocks for the Long Run, "Limits on real gross domestic product (GDP) growth put a lid on long-term profit growth."
Unfortunately, we still don't fully understand the process of asset pricing, and it's not clear that we ever will. To some extent, Mr. Market's internal rules are a black box to outsiders, which prompts some to argue that market behavior is chaotic and irrational, particularly in the short term. For example, there's no clear correlation between economic growth, earnings and equity returns.
Nonetheless, if we step back and consider the big picture, the timing of last year's extraordinary stock market volatility wasn't coincidental. We can debate whether equity prices fell too far and too fast. Yet it's no accident that the steep losses in stocks last year arrived after the start of a deep recession, one that began in December 2007, according to the National Bureau of Economic Research.
The association of economic cycles with bull and bear markets is as old as capitalism. The question is whether we can learn more about market behavior beyond superficial observations. The answer is yes, even if there are no magic bullets that offer quick and easy profits. But as researchers study the equity risk premium, we gain a deeper understanding of asset pricing and what it means for asset allocation. And that means we might be able to improve the quality and timeliness of investment decisions. Maybe.
The fact that researchers are even looking at the economy and the markets under one theoretical roof is an achievement.
Theorists in this dismal science may seem to be one big happy family to outsiders, but there are many divides, including the one that separates the study of macroeconomics from financial markets. Economists have mostly focused on one or the other, each side developing models but looking across the aisle only infrequently.
And that's not totally surprising. Macroeconomic data tends to arrive with substantial lags. Wall Street, by comparison, runs on real-time information. No wonder that crafting an investment outlook with broad economic analysis isn't popular. Similarly, macroeconomic forecasts have relied minimally, if at all, on financial market signals. One reason is that the short-term volatility in financial markets appears irrelevant for deciphering broad economic trends over multiyear periods.
But the walls are coming down, and strategic-minded investors are the beneficiaries. For example, a recent study shows how forecasts of business conditions also appear to do a good job of predicting the equity risk premium. For instance, when economic growth is expected to be low or negative, the expected equity risk premium is relatively high, according to the report Stock Returns and Expected Business Conditions: Half a Century of Direct Evidence (by Sean D. Campbell and Francis X. Diebold, writing in the Journal of Business & Economic Statistics, April 2009). The study analyzes equity returns in the context of economic forecasts over the past 50 years via the respected Livingston Survey, a semiannual review of economists' expectations published by the Federal Reserve Bank of Philadelphia.
The study of relationships between the economy and the stock market is not a new field, but it is a relatively young one. Stock market volatility has been studied extensively, for instance, but the literature examining the reasons for it is thin by comparison. That means new research on this front will be all the more intriguing.
That includes a chapter in the forthcoming book Volatility and Time Series Econometrics (published by Oxford University Press), which explains how economic cycle volatility drives stock market volatility rather than the other way around. Previous research may have considered the association between the equity markets and economic activity, but this piece (co-authored by professors Francis X. Diebold and Kamil Yilmaz) lays out the relationship on a deeper level.
The authors have found among other things that countries with relatively high gross domestic product (GDP) growth volatility tend to have more volatile stock markets. Another insight-and a surprising one-is that while the stock market is generally pricing securities based on expectations about the future, it's usually the reverse with volatility, which is to say that Mr. Market seems to react to volatility. Part of the reason is that every country's GDP volatility is the main source of its stock market volatility: The former drives the latter, and so the market seems to digest the results after the fact.
Recognizing that volatility flows from the economy to the equity market is hardly a shortcut to fast profits. Then again, no lone piece of information about market behavior tells us everything. The practical value of studying macroeconomics and asset pricing behavior comes from synthesizing intelligence dispensed from the two halves. This isn't easy, but the lesson is clear: The biggest obstacle for investors is failing to see the forest for the trees.
Financial economists have spent quite a bit of the last 30 years identifying individual factors that help explain returns in the capital markets. But analyzing the individual components in connection with one another is still quite new. The early results are encouraging, and recent studies suggest that we're just beginning to understand how these factors, when taken together, can deliver better estimates of the equity risk premium.
For a glimpse into the new world order, take a look at this forthcoming study in the Review of Financial Studies: "Out-of-Sample Equity Premium Prediction: Combination Forecasts and Links to the Real Economy," by professor David Rapach and two co-authors. The paper shows that analysts' forecasting ability improves when factors are used collectively. It's essential to combine them since any one measure's ability to offer relevant insight about the future waxes and wanes over time.