Macro Risk and Equity Returns: Have We Learned Anything Yet?

by: James Picerno

The case for mean reversion is alive and well when it comes to developing intuition about future returns in the equity market, as I discussed earlier this week. True, you can't prove anything definitively in the money game, but the empirical record is persuasive for thinking the expected returns in the stock market will fluctuate a) dramatically over time and b) with some degree of consistency in connection with fundamental value measures, such as dividend yield, p/e ratio, book value and other metrics.

The insight doesn't help much when it comes to short-term trading, but it provides a fair amount of strategic insight. But that leaves open the question of why return varies so much in the first place?

The answer, of course, is linked with the changes in the broader economy. There's lots of debate about the specifics, although there's a growing body of research that finds that macroeconomic volatility is the primary factor for major swings in financial market prices. Some critics argue it's the other way around and that market crashes sometimes, if not always, trigger recessions. But that's an increasingly outdated view of how markets and economies interact. That was argument outlined by John Kenneth Gailbraith in the 1950s in his popular book The Great Crash 1929.

Some still embrace this idea, such as Richard Posner's recent book A Failure of Capitalism. But many economists describe a more nuanced view in the 21st century. That is, the equity risk premia varies because of macroeconomic volatility. Some strands of this research, such as Robert Barro's "Rare Disasters and Asset Markets in the Twentieth Century" (2006, Quarterly Journal of Economics) argues that the high risk premium in stocks is connected with the risk of economic implosion. As Barro writes,

The potential for rare economic disasters explains a lot of asset-pricing puzzles.

Perhaps the empirical smoking gun is the fact that the stock market peaks ahead of recessions, as formally defined by NBER. That was certainly true for the Great Recession, which began in December 2007, as per NBER. The stock market (S&P 500) peaked two months earlier.

Economists continue to analyze this apparent relationship on a deeper level, with intriguing results. For example, last year's working paper by Francois Gourio at Boston University offers a model in which

…risk premia vary because the real quantity of risk varies, leading to a reaction of both asset prices and macroeconomic aggregates. An increase in the probability of disaster creates a collapse of investment and a recession, as risk premia rise, increasing the cost of capital. Demand for precautionary savings increase, leading the yield on less risky assets to fall, while spreads on risky securities increase.

Another paper from last year ("The cyclical component of US asset returns" by D. Backus, et al.) reports that "equity returns, the term spread, and excess returns on a broad range of assets are positively correlated with future economic growth." The paper goes on to note:

We look at asset prices from the perspective of macroeconomists and ask: What do they tell us about the structure of the economy that generated them? We document two sets of facts that we think are worth exploring further. The first is the well-known tendency for equity prices (or their growth rates) and term spreads (differences between long- and short-term interest rates) to lead the business cycle. In US data, and to some extent in data for other countries, fluctuations in these variables are positively correlated with economic growth up to 6 to 9 months in the future.

Of course, if markets are anticipating changes in the economic cycle, that opens the door to the idea that market shifts are partially responsible for the fluctuations in the economy. Maybe Gailbraith was right after all? Then again, one can argue that markets are simply anticipating a new round of economic volatility. In other words, don't blame the messenger.

The fact that the causes of the business cycle are still hotly debated reminds that there's plenty of room for disagreement on all sides. Perhaps Eugene Fama was right when he said:

We don’t know what causes recessions. Now, I’m not a macroeconomist so I don’t feel bad about that. [Laughs again.] We’ve never known. Debates go on to this day about what caused the Great Depression. Economics is not very good at explaining swings in economic activity.