Better predictions of share yields

It is by no means a simple matter to say anything with confidence about how the value of a share will develop over time. There is a varied menu of key figures and indicators that are used to consider various investment alternatives.

Not all such measures are equally accurate and it is far from certain that they have predictive value.

Some people, perhaps particularly corporate and financial journalists, have fun seeing whether the dartboard method gives better results than following the advice of the experts. And sometimes it does, too.

In search of better prognoses

Financial researchers all over the world have long been in search of indicators that can yield more reliable prophecies about future yields on the stock markets.

Associate Professor Ilan Cooper and Professor Richard Priestley of the Department of Financial Economics at BI Norwegian School of Management have now discovered a macroeconomic variable, the “output gap”, which can be used to predict stock market yields.

This indicator provides good predictions of future yield on shares within a time horizon right down to one month and up to five years. The longer the time horizon, the more reliable the prediction.

The output gap is a measure of the pressure in the economy and is calculated as a deviation from its long-term growth rate. The output gap fluctuates in step with the business cycle.

Top international publication

Cooper and Priestley have undertaken extensive tests of the output gap as an indicator of future yield on shares.

Among other things they have conducted statistical analyses of the yield in the stock markets of the G7 countries (France, Germany, Italy, Japan, the UK, the US and Canada) in the period from 1970 to 2005.

“The output gap can predict stock market returns in the G7 countries (for example the yield on the S&P 500 index in the USA) and expected additional yield in relation to risk-free interest rates”, conclude the financial researchers.

The macro indicator can also be used to predict future returns on US long-term bonds.

Cooper and Priestley present the results of their study in the article “Time-Varying Risk Premiums and the Output Gap”, published in the international journal The Review of Financial Studies.

The journal is considered one of the three most reputable within the discipline of financial economics.

Higher expected return during recessions

When the economy is booming, the output gap will be positive, but negative in bad times.

In their study Cooper and Priestley found that expected returns are higher during recessions than during recovery.

“We show that investors are risk-averse during recessions. They want a higher risk premium to invest in shares rather than government bonds,” they say.

The study shows that the yield in the share market is closely related to the macroeconomic figure the output gap. Stock-market investors who calculate the output gap and use it to predict future earnings in the market will do better than those who do not use it, say the BI researchers. On the other hand, what they earn extra in bad times is a compensation for the higher risk.

Reference:

Cooper, Ilan and Priestley, Richard (2008): ”Time-Varying Risk Premiums and the Output Gap” (Forthcoming, published online on October 2, 2008), The Review of Financial Studies.