DP16357 Equity premium predictability over the business cycle
|Author(s):||Emanuel Moench, Tobias Stein|
|Publication Date:||July 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.