Predicting Stock Returns in an Efficient Market

TLDR

An intertemporal general equilibrium model links financial asset returns to serially correlated aggregate output, implying that predictable output should allow prediction of stock returns. The model posits that output changes prompt consumption smoothing, raising the required return on assets. Empirical evidence confirms that stock returns are a predictable function of aggregate output, supporting the model’s implications.

Abstract

ABSTRACT An intertemporal general equilibrium model relates financial asset returns to movements in aggregate output. The model is a standard neoclassical growth model with serial correlation in aggregate output. Changes in aggregate output lead to attempts by agents to smooth consumption, which affects the required rate of return on financial assets. Since aggregate output is serially correlated and hence predictable, the theory suggests that stock returns can be predicted based on rational forecasts of output. The empirical results confirm that stock returns are a predictable function of aggregate output and also support the accompanying implications of the model.