DP16357 Equity premium predictability over the business cycle

Author(s): Emanuel Moench, Tobias Stein
Publication Date: July 2021
Date Revised: September 2021
Keyword(s): Business cycle, Probit Model, Recession predictability, return predictability, term spread
JEL(s): C53, E32, E37, G11, G17
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=16357

The equity premium follows a pronounced v-shape pattern around the beginning of recessions. It sharply drops into negative territory just before business cycle peaks and then strongly recovers as the recession unfolds. Recessions are preceded by an inverted yield curve. Thus probit models using the term spread as predictor time the beginning of recessions well. We show that such model-implied recession probabilities strongly improve equity premium prediction out-of-sample. We document a structural break in the mean of the term spread in 1982. When correcting for this break, the forecast performance further strengthens, outperforming other recently proposed benchmark predictors.