DP14115 The Leverage Factor: Credit Cycles and Asset Returns

Author(s): Josh Davis, Alan M. Taylor
Publication Date: November 2019
Keyword(s): asset allocation, Asset Pricing, Cycles, debt, leverage, return predictability
JEL(s): E17, E20, E21, E32, E44, G01, G11, G12, G17, G21, N10
Programme Areas: Financial Economics, Economic History, Monetary Economics and Fluctuations, Macroeconomics and Growth
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=14115

Research finds strong links between credit booms and macroeconomic outcomes like financial crises and output growth. Are impacts also seen in financial asset prices? We document this robust and significant connection for the first time using a large sample of historical data for many countries. Credit boom periods tend to be followed by unusually low returns to equities, in absolute terms and relative to bonds. Return predictability due to this leverage factor is distinct from that of established factors like momentum and value and generates trading strategies with meaningful excess profits out-of-sample. These findings pose a challenge to conventional macro-finance theories.