Equity premium predictability over the business cycle

, and Tobias Stein
Authors registered in the RePEc Author Service: Emanuel Moench

No 16357, CEPR Discussion Papers from Centre for Economic Policy Research

Abstract: 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.

Keywords: Recession predictability; Return predictability; Business cycle; Probit model; Term spread (search for similar items in EconPapers)
JEL-codes: C53 E32 E37 G11 G17 (search for similar items in EconPapers)
Date: 2021-09
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Working Paper: Equity premium predictability over the business cycle (2021)
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