Stock Returns and Expected Business Conditions: Half a Century of Direct Evidence

Abstract

Using survey data, we characterize directly the impact of expected business conditions on expected excess stock returns. Expected business conditions consistently affect expected excess returns in a counter-cyclical fashion. Moreover, inclusion of expected business conditions in otherwise-standard predictive return regressions substantially reduce the explanatory power of the conventional financial predictors, including the dividend yield, default premium, and term premium, while simultaneously increasing R². Expected business conditions retain predictive power even when including the key nonfinancial predictor, the generalized consumption/wealth ratio. We argue that time-varying expected business conditions likely capture time-varying risk, whereas time-varying consumption/wealth may capture time-varying risk aversion.

KEY WORDS::

• Business cycle
• Equity premium
• Expected equity returns
• Livingston survey
• Prediction
• Risk aversion
• Risk premium