Equity premium predictability over the business cycle

Emanuel Moench and Tobias Stein

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

Abstract: Equity returns follow a pronounced v-shape pattern around the onset of recessions. They sharply drop into negative territory just before business cycle peaks and then strongly recover as the recession unfolds. Recessions are typically preceded by a flat yield curve. Probit models relying on the term spread as a predictor therefore time the beginning of recessions well. We show that model-implied recession probabilities based on the term spread strongly improve equity premium prediction in- and out-of-sample and outperform several benchmark predictors. Correcting for a structural break in the mean of the term spread in 1982 further strengthens the forecast performance.

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: 2021-07
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Journal Article: Equity Premium Predictability over the Business Cycle (2026)
Working Paper: Equity premium predictability over the business cycle (2021)
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