Swiss National Bank Working Papers

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1 01-10 Swss Naonal Bank Workng Papers Global and counry-specfc busness cycle rsk n me-varyng excess reurns on asse markes Thomas Nschka

2 The vews expressed n hs paper are hose of he auhor(s and do no necessarly represen hose of he Swss Naonal Bank. Workng Papers descrbe research n progress. Ther am s o elc commens and o furher debae. Copyrgh The Swss Naonal Bank (SNB respecs all hrd-pary rghs, n parcular rghs relang o works proeced by copyrgh (nformaon or daa, wordngs and depcons, o he exen ha hese are of an ndvdual characer. SNB publcaons conanng a reference o a copyrgh ( Swss Naonal Bank/SNB, Zurch/year, or smlar may, under copyrgh law, only be used (reproduced, used va he nerne, ec. for non-commercal purposes and provded ha he source s menoned. Ther use for commercal purposes s only permed wh he pror express consen of he SNB. General nformaon and daa publshed whou reference o a copyrgh may be used whou menonng he source. To he exen ha he nformaon and daa clearly derve from ousde sources, he users of such nformaon and daa are oblged o respec any exsng copyrghs and o oban he rgh of use from he relevan ousde source hemselves. Lmaon of lably The SNB acceps no responsbly for any nformaon provdes. Under no crcumsances wll accep any lably for losses or damage whch may resul from he use of such nformaon. Ths lmaon of lably apples, n parcular, o he opcaly, accuracy, valdy and avalably of he nformaon. ISSN (prned verson ISSN (onlne verson 01 by Swss Naonal Bank, Börsensrasse 15, P.O. Box, CH-80 Zurch

3 Global and counry-specfc busness cycle rsk n me-varyng excess reurns on asse markes Thomas Nschka 1 Swss Naonal Bank Absrac Devaons of naonal ndusral producon ndexes from rend explan me varaon n excess reurns on he G7 counres sock markes. Ths paper hghlghs ha hs fndng s drven by a global, common componen n he naonal producon gaps. The global componen s no a mrror mage of he U.S. busness cycle. Que o he conrary, a res-ofhe-world producon gap explans me varaon n U.S. sock marke excess reurns whle he U.S.-specfc producon gap does no. However, boh U.S.-specfc and global gap componens explan me-varyng excess reurns on U.S. bonds. The relave mporance of he U.S.-specfc rsk gap ncreases wh he maury of bonds. JEL: E3, F44, G15 Keywords: bond reurn, busness cycle rsk, excess reurns, ndusral producon, predcably, sock reurn 1 Malng address: Thomas Nschka, Moneary Polcy Analyss, Swss Naonal Bank, Börsensrasse 15, P.O. Box, CH-80 Zurch; Phone: +41-( ; FAX : +41 ( ; E-mal: homas.nschka@snb.ch The paper benefed from commens and suggesons by Jonahan Benchmol (dscussan, an anonymous referee of he SNB workng paper seres as well as parcpans n a SNB Brown Bag Semnar, he BMC-QASS 01 conference on Macro and Fnancal Economcs, he 4 h IFABS conference and he 9 h GdE Annual Inernaonal Symposum on Money, Bankng and Fnance. Any errors and omssons are my own. The vews expressed n hs paper do no necessarly reflec he sance of he Swss Naonal Bank. 1

4 1 Inroducon Basc asse prcng heory suggess ha me seres and cross-seconal varaon n asse reurns should be relaed o macroeconomc rsk facors. In lne wh heory and earler evdence (see Cochrane (005 for an excellen survey of he leraure, Cooper and Presley (009 show ha he devaon of ndusral producon from rend (producon gap or oupu from rend (oupu gap predcs excess reurns on he U.S. sock and bond marke n- and ouof-sample. A negave producon gap predcs hgh excess reurns and vce versa. The nsample forecasng power of naonal producon gaps for naonal sock marke reurns perans also o he oher G7 counres. Ths laer fndng s parcularly neresng for a leas wo reasons. Frs, n conras o he producon gap, he record of oher purely macroeconomc forecas varables for sock marke reurns s raher mxed n nernaonal comparson. For nsance, shor-run varaon n he U.S. consumpon-wealh rao predcs U.S. sock marke reurns (Leau and Ludvgson, 001. Ths fndng also perans o consumpon-wealh raos of oher Anglo-Saxon counres (Fernandez-Corugedo e al., 003; Fsher and Voss, 004; Tan and Voss, 003; Ioanndes e al., 006 bu her German or Japanese counerpars do no predc he respecve German or Japanese sock marke excess reurns (Hamburg e al., 008; Nagayasu, 009. Second, he G7 counres ndusral producon gaps are sgnfcanly and posvely correlaed wh each oher. Correlaons of around 0.5 are common. Hence, a pror, s no clear f he predcve power of he naonal producon gaps s he oucome of common, global varaon n producon gaps or due o her counry-specfc dynamcs. Earler sudes hghlgh he mporance of global fnancal marke rsk facors as explanaon of naonal sock markes me varaon (e.g. Bekaer and Harvey, 1995; Campbell and Hamao, 199; Chan e al., 199; Dumas and Sonk, 1995; Ferson and Harvey, 1993; Harvey, angvd (006 scales sock prces wh GDP o show ha hs sock prce o GDP rao s a powerful predcor of sock marke reurns nernaonally. By consrucon, however, hs s no a purely macroeconomc varable. 1

5 1991. Moreover, Guo (006 and Nschka (010 provde evdence for he mpac of global, busness cycle relaed rsk on naonal sock markes by showng ha he U.S. consumponwealh-rao does no only predc U.S. bu also foregn sock marke reurns. ecenly, Cooper and Presley (01 show ha swngs n he world capal sock o oupu rao predc naonal sock marke reurns of developed counres n- and ou-of-sample. The man emprcal resuls of hs paper suppor he vew ha global macroeconomc rsk plays an mporan role for explanaons of me-varaon n expeced asse reurns. The evdence presened n hs paper reveals ha sock marke reurn predcably by naonal producon gaps s prmarly drven by common varaon n he producon gaps. The man fndngs of hs paper are robus o a range of conrols, hold across subsample perods, peran a dfferen forecas horzons, reman qualavely unalered when daa s measured a lower han he monhly frequency and are suppored n sascal ess of ou-of-sample predcably. Assessmens of he mporance of global rsks for me varaon n sock marke excess reurns have ypcally reled on regressons of foregn sock marke reurns on U.S. forecas varables so far. The predcve power of he U.S. varables has been nerpreed as evdence for he presence of a common componen n sock marke reurns (e.g. Campbell and Hamao, 199; Guo, 006; Nschka, 010. Ths paper dffers from hese sudes. I provdes drec evdence for he presence of global macroeconomc rsk drvng me varaon n sock marke reurns. Ths paper hus adds complemenary nsghs o Cooper and Presley (01 who reveal he explanaory power of world busness cycle flucuaons, measured n he world capal sock o oupu rao, on naonal sock marke reurns. The world capal sock o oupu rao, however, feaures also he U.S. capal sock o oupu rao whch could be a major drver of her resuls. The approach followed n hs paper allows o address such concerns. 3

6 Moreover, hs paper reveals ha foregn macroeconomc rsk s mporan n order o explan me varaon n excess reurns on he U.S. sock marke. To he bes of my knowledge, here has been lle evdence of he mpac of foregn macroeconomc rsk on U.S. sock marke rsk prema so far. I explo hs laer fndng o assess he relave mporance of global and counry-specfc rsk for he explanaory power of he U.S. producon gap for U.S. bond excess reurns oo. Ths paper fnds ha boh global and U.S.-specfc pars of he U.S. producon gap explan me varaon n U.S. bond excess reurns. Ths observaon echoes recen evdence by Dahlqus and Hasselof (011 who show ha boh global and local versons of he Cochrane and Pazzes (005 bond rsk facor smulaneously predc bond excess reurns n he US, UK, Germany and Swzerland. Despe evdence for he mporance of global rsk for naonal bond excess reurns (Borr and Verdelhan, 011; Cooper and Presley, 01; Ilmanen, 1995, counry-specfc macroeconomc dynamcs hence also play an mporan role n explanng bond excess reurns. Taken ogeher, he man fndngs of hs paper renforce he pon ha ruly global busness cycle rsk, no necessarly concdng wh U.S. macroeconomc rsk, s an mporan explanaon of me-varyng excess reurns on naonal asse markes. Ths s parcularly rue for sock markes bu he emprcal analyss of hs paper also shows ha global rsk s mporan o undersand dynamcs of bond excess reurns. However, he mpac of counryspecfc macroeconomc rsk s no neglgble n ha conex. Ths paper hus conrbues o recen sudes ha deal wh he queson f common (macroeconomc rsk facors drve dfferen asse markes (e.g. Asness e al., 011; Bansal and Shalasovch, 010; Bekaer e al., 009; Hasselof, 010; Kojen e al., 010; Verdelhan, 011. I s mporan o bear n mnd ha hs paper assesses he mporance of global vs. counryspecfc rsk embedded n one sngle macroeconomc forecas varable. Ths paper does no assess he general queson how srongly global or counry-specfc macroeconomc rsk affec me seres varaon n asse reurns. There s evdence ha global macroeconomc rsk plays 4 3

7 an mporan role n hs respec and hs paper suppors hs vew. Bu hs s no anamoun o sayng ha counry-specfc rsks play no role. A number of sudes provde evdence for he mporance of local rsk facors n asse reurns, especally n emergng markes. Examples nclude Bekaer (1995 and Harvey (1995 who show ha local facors are mporan when assessng he predcably of emergng sock marke s rsk prema or Bekaer e al. (007 who hghlgh he mporance of counry-specfc lqudy rsk n emergng counres sock marke reurns. The remander of he paper s srucured as follows. Secon provdes nformaon abou he daa employed n hs sudy as well as he calculaon of he producon gap. Secon 3 presens he economerc framework and he man emprcal resuls for he predcably of sock marke reurns. Secon 4 assesses he mpac of global and counry-specfc busness cycle rsk on U.S. bond excess reurns. Secon 5 concludes. The appendx addresses a more general pon and shows ha s approprae o neglec he poenal feedback of sock reurns on he real economy n he presen conex. Daa, defnon of producon gap and excess reurns Counry coverage and baselne sample perod The counres under sudy are Canada, France, Germany, Ialy, Japan, he UK and he US. The baselne sample perod runs from January 1970 o February 011. Due o lmed daa avalably, he sample perod for he U.S. bond predcably assessmen spans only he perod from January 1970 o December 003. Defnon of producon gap To calculae he producon gaps, I follow Cooper and Presley (009 and regress he naural logarhm of each of he G7 counres monhly and seasonally adjused ndusral producon ndexes from he IMF's Fnancal Sascs on a lnear and quadrac me rend,.e. p = α + βrend + γrend + ε 5 (1 4

8 n whch p represens he log ndusral producon ndex of counry a me, rend denoes a me rend and he resdual of hs regresson, ε, consues he producon gap as defned n Cooper and Presley ( The producon gap for counry, gap. Sock marke excess reurns ε, s henceforh denoed I use monhly reurns on he G7 counres MSCI gross sock ndexes,.e. ndexes ha assume dvdends are renvesed, denomnaed n local currency and monhly shor-erm neres raes from he IMF's Fnancal Sascs o calculae sock marke excess reurns. The logarhmc excess reurn s defned as he log sock marke reurn a he end of he monh mnus he shorerm neres rae a he end of he prevous monh, r f +1 r. The shor-erm neres raes are reasury bll raes for Canada, he UK and he U.S. and money marke raes for France, Germany, Ialy and Japan. They are obaned from he IMF s Inernaonal Fnancal Sascs. The sock marke ndex daa are freely avalable on All of he resuls presened n he subsequence reman unaffeced f I use prce ndexes,.e. ndexes whch assume ha dvdend paymens are no renvesed, or sock ndexes denomnaed n U.S. dollar nsead of local currences. Neher dvdend growh nor exchange rae changes are predcable by he producon gap varees consdered n hs paper. In addon, all of he resuls reman qualavely unaffeced f I consder real sock marke reurns nsead of excess reurns n he forecas regressons. These resuls are no presened bu avalable upon reques. U.S. bond excess reurns Annual U.S. bond excess reurns a he monhly frequency are obaned from borrowng a he one-year yeld on a one-year maury bond n a gven monh, buyng a longer-erm (wo o 3 Cooper and Presley (009 consder four dfferen defnons of an oupu gap for he U.S., bu for reasons of daa avalably focus on he one obaned from equaon (1 n her assessmen of he G7 counres. 6 5

9 fve years bond and sellng ha longer-erm bond afer one year,.e. he bond excess reurn obeys brx + = p p y ( N N 1 N where p sands for log bond prces, N denoes he maury of bonds n years and y s he log yeld on a bond obeyng y N N p =. Ths paper uses he Fama and Blss bond daa from he N CSP daabase as n Cochrane and Pazzes ( Term spreads I use erm spreads, he dfference beween long-erm governmen bond yelds and shor-erm raes (3-monh -blls or call money marke raes, as conrol varable n mulvarae forecas regressons. The source s agan he IMF s Inernaonal Fnancal Sascs. Dvdend-prce raos As addonal conrol varable, hs paper uses he counry-specfc dvdend-prce raos. I follow Fama and French (1988 and e.g. Goyal and Welch (008 and consruc for each counry he dvdend-prce rao by summng up monhly dvdends on he respecve MSCI sock ndex from he 1 monhs precedng monh. The log of dvdends mnus he log of he sock prce ndex a me s he dvdend-prce rao. The monhly dvdends are obaned from he oal reurn and sock prce ndexes of he counres under sudy. In each monh he dvdend for a gven counry s calculaed as dfference n he reurn on he oal reurn and he reurn on he respecve counry s prce ndex mes he prce ndex a he end of he prevous monh. 4 John Cochrane gracously makes hs daa publcly avalable on hs webse hp://faculy.chcagobooh.edu/john.cochrane/ 7 6

10 3 Economerc specfcaons and resuls of sock reurn predcably regressons Producon gaps of he G7 counres predc excess reurns on he respecve naonal sock markes (Cooper and Presley, 009. However, able 1 dsplays ha he parwse correlaons beween he G7 counres producon gaps for he me perod from 1970 o 011 are all posve, sascally sgnfcan and coeffcens of 0.5 or hgher are no uncommon. The predcve power of naonal producon gaps could hence be relaed o a common, global componen. [abou here Table 1] To evaluae hs hypohess, I run one-monh ahead, n-sample, forecas regressons of he excess reurns on he G7 counres sock markes on a res-of-he-world producon gap from each of he G7 counres perspecve. As a furher es of hs hypohess, I dsngush beween common and dosyncrac componens n naonal producon gaps and es he predcve ably of hese wo componens n he presence of he erm spread, anoher powerful predcor of sock marke excess reurns nernaonally (Hjalmarsson, 010, and he counry-specfc dvdend-prce raos. Secon 3.1 presens he correspondng resuls. In addon, I check wheher he resuls are robus across subsample perods and f hey hold when ncreasng he forecas horzon above one monh. Secons 3. and 3.3 provde hese resuls. Moreover, I assess f he resuls hold when he daa s measured a lower han he monhly frequency and he common componen n naonal producon gaps s drecly obaned from a prncpal componen analyss. Secons 3.4 and 3.5 presen hese resuls. Fnally, secon 3.6. assesses f he nformaon on he dfferen producon gap componens could have helped nvesors n real me nvesmen decsons,.e. ou-of-sample predcably. 8 7

11 3.1 In-sample forecas regressons: Common or dosyncrac rsk n naonal producon gaps? Ths secon provdes an assessmen of he hypohess ha he predcve power of producon gaps for excess reurns on he G7 sock markes n Cooper and Presley (009 s drven by common, busness cycle relaed rsk. Ths assessmen consss of wo pars Evdence from unvarae regressons The frs par of he assessmen proceeds n hree seps. Frs, I presen resuls from a rerun of he Cooper and Presley (009 one-monh ahead forecas regressons of he G7 counres sock marke excess reurns on naonal producon gaps,.e. r e, = + β gap α + ν (3 wh e r, he monhly excess reurn on one of he G7 sock markes and gap he respecve counres producon gap obaned from equaon (1. The forecas regresson follows Cooper and Presley (009 n usng he second lag of gap because ndusral producon ndex daa s ypcally publshed wh a lag,.e. he ndusral producon ndex daa for monh -1 s publshed n he mddle of he perod -1 o (see also Chen e al., Snce he sample n hs sudy covers fve addonal years of daa compared o Cooper and Presley (009 and ncludes he recen fnancal crss and he grea recesson, hs rerun serves as a robusness check f he predcve power of naonal producon gaps for naonal sock marke reurns sll holds. In a second sep, I consruc a res-of-he-world producon gap, defned as gap G7 1 = K K k = 1 gap k (4 where K= 7 and k denoes he G7 counres oher han counry and assess f hs res-of-heworld producon gap predcs excess reurns on he sock marke of counry,.e. r e, = G7 α + β gap + ν (5 9 8

12 In words, f, for example, represens Canada, hen he res-of-he-world producon gap s he arhmec average of he oher sx G7 counres producon gaps. I hen assess f hs average producon gap of he oher counres predcs he excess reurn on he Canadan sock marke. If represens France, hen he res-of-he-world producon gap s he average producon gap of he G7 counres excludng France, ec. In he hrd sep, I assess f he res-of-he-world producon gap could be replaced by he U.S. producon gap. Ths assessmen s movaed by fndngs of Campbell and Hamao (199 who show ha predcve varables of U.S. sock marke reurns also predc Japanese sock marke reurns and Guo (006 as well as Nschka (010 who provde evdence for he forecas power of shor-run varaons n he U.S. consumpon-wealh rao for foregn sock marke reurns. The forecas equaon hen akes he followng form: r e, α gap + ν US = + β (6 Table summarzes he resuls of hs frs assessmen. Column (I presens he esmaes from equaon (4, column (II gves he esmaes from equaon (5 and column (III dsplays he esmaes from equaon (6. Newey-Wes (Newey and Wes, 1987 correced -sascs appear below he esmaes n parenhess. Snce he gaps are generaed regressors and he sample sze of almos 500 monhly observaons does no guaranee ha asympoc dsrbuon heory apples, I follow Hoffmann (011 and addonally assess he sascal sgnfcance of he esmaes by regardng Valkanov (003 correced -sascs. Valkanov suggess o dvde he sandard -sasc by he square roo of he sample sze. Ths correced -sasc allows o address concerns abou he perssence of regressor and small sample bas. Ths s parcularly helpful for nference from long-horzon regressons when he mpac of perssen regressors more of a concern han n he curren regresson seup. Crcal values for hs sasc are obaned by generang normally dsrbued me seres n he sample sze and regressng hs arfcally generaed, heorecally sound,.e. unpredcable, seres on he gap varees. Even hough only Newey-Wes (1987 correced -sascs are repored, asersk n 10 9

13 he ables ndcaes ha he esmae s sgnfcan a 95% confdence level for boh Newey- Wes (1987 and Valkanov (003 correced -sascs. The sample perod runs from January 1970 o February 011. The resuls presened under column (I of able confrm ha he paern observed by Cooper and Presley (009 also holds n hs longer sample perod. In fac, he resuls are even sronger n erms of sascal sgnfcance. A negave naonal producon gap oday predcs posve excess reurns on he respecve naonal sock marke one monh ahead. The esmaes are sascally sgnfcan a he 95% confdence level for all of he G7 counres excep Canada. The naonal producon gaps explan beween 1% and % of he me varaon n sock marke excess reurns one-monh ahead. Is hs predcve power he reflecon of common, macroeconomc rsk? The esmaes under column (II of able gve some ndcave evdence whch suppors hs hypohess. For all of he G7 counres, wh he excepon of Ialy, he average producon gap of he oher sx G7 counres predcs he counry s sock marke excess reurn ha s excluded from he producon gap consrucon. Ineresngly, he res-of-he-world producon gap predcs he Canadan sock marke excess reurn whle he Canadan producon gap does no. Conversely, he Ialan producon gap predcs he respecve naonal sock marke excess reurn whle he res-of-he-world producon gap does no. Ths fndng suggess ha an dosyncrac componen n he Ialan producon gap s responsble for s forecas ably of sock marke excess reurns. I also noeworhy ha he U.S. sock marke reurn s predcable by he average producon gap of he oher sx G7 counres. So far here s ample evdence for he predcve power of U.S. varables for foregn sock marke reurns whch s ypcally nerpreed as evdence for he presence of a common, global drvng force of me varaon n sock markes (e.g. Campbell and Hamao, 199; Guo, 006; Nschka, 010. Campbell and Hamao (199 show ha U.S. fnancal marke varables ha explan me varaon n he U.S. sock marke reurn sgnfcanly predc Japanese sock marke reurns. By conras, 11 10

14 Japanese predcve varables, such as he dvdend-prce rao, do no raonalze me varaon n U.S. sock marke reurns. To he bes of my knowledge, here has been lle drec evdence for he predcably of U.S. sock marke reurns by foregn macroeconomc varables as of ye. Ths sudy flls hs gap. Ths laer observaon s relaed o he queson f he res-of-he-world producon gap s n fac drven by he U.S. producon gap and hus f he evdence presened so far reflecs he drec mpac of U.S. busness cycle condons. The esmaes from equaon (6 presened under column (III of able sugges ha hs s no he case. The U.S. producon gap alone has some explanaory power for he UK sock marke excess reurn bu no for excess reurns on he oher G7 counres sock markes. The evdence of predcably by he res-of-heworld producon gaps s hence unlkely a drec reflecon of he U.S. busness cycle. [abou here Table ] 3.1. Evdence from mulvarae regressons dsngushng common and dosyncrac producon gap componens The frs par of he assessmen f he predcve power of naonal producon gaps for naonal sock marke excess reurns reflecs common busness cycle rsk leaves he mpresson ha ndeed global rsk plays an mporan role n hs respec. The second par of he assessmen res o dsngush explcly beween common and dosyncrac macroeconomc rsks by decomposng he naonal producon gaps no one componen ha s perfecly correlaed wh he respecve res-of-he-world producon gaps and he orhogonal componen nerpreed as counry-specfc par of he producon gap. Therefore, I run he followng regresson gap = G7 α + β gap + ν (7 o oban he componen n producon gaps ha s perfecly correlaed wh he res-of-heworld producon gaps, β gap G 7 whch s henceforh denoed common, gap. The componen 1 11

15 ha s orhogonal o, ν + 1, s nerpreed as he dosyncrac componen and henceforh denoed do, gap. I use hese componens o provde furher evdence on he source of he predcve power of naonal producon gaps by runnng regressons on he common and dosyncrac producon gap componens alone and check also wheher he erm spread, he dfference n yelds ( n percenage pons p.a. on a long-erm governmen bond and a shor-erm rae, alers any of he conclusons drawn so far. Hjalmarsson (010 shows ha predcve varables consruced from neres raes, especally he erm spread, are more robus predcors of sock reurns han prce-earnngs or dvdend-prce raos nernaonally. Includng he naonal erm spreads should hence be a good and parsmonous robusness es of he producon gap componens explanaory power for me varaon n sock marke excess reurns n hs nernaonal conex. As an alernave conrol, I also consder he counry-specfc dvdend-prce rao. The forecas regressons obey r e, α β gap β gap + ν common, do, = (8 and ncludng he erm spread r e, α β gap β gap β s + ν common, do, = (9 or he dvdend-prce rao r e, common, do, = + β1 gap + β gap + β 3dp 1 α + ν (10 Table 3 summarzes he resuls. Column (I dsplays he esmaes from equaon (8. Column (II presens he esmaes from equaon (9. Column (III gves he esmaes from regresson (10. Newey-Wes (Newey and Wes, 1987 correced -sascs appear below he esmaes n parenhess. Agan, asersk denoes sgnfcance a he 95% level judged by Newey-Wes and Valkanov (003 correced -sascs a he same me. The sample perod runs from January 1970 o February 011. The resuls renforce he mpresson lef by he forecas regresson resuls presened n able. 13 1

16 Column (I of able 3 shows ha for all of he G7 counres, s he common componen n producon gaps,.e. ha componen ha s perfecly correlaed wh he average producon gap across he oher sx counres, ha forecass sock marke excess reurns. Agan Ialy s he only excepon. As conjecured before, s he dosyncrac componen n he Ialan producon gap ha explans me varaon n he Ialan sock marke excess reurn. Column (II of able 3 shows ha he man concluson remans unalered when akng he respecve counres erm spread as addonal predcve varable no accoun. The ncluson of he erm spread drves ou he sascal sgnfcance of he common producon gap s regresson coeffcen for Canada. All of he oher counres resuls do no change. The erm spread self does no explan he varaon of he sock marke excess reurns n he presence of he wo producon gap componens. Ths fndng should no be oo surprsng snce he erm spread and he producon gap should boh rack busness cycle relaed varaon n sock reurns (Cooper and Presley, 009. In he regressons presened above could eher be drven ou by he presence of he common or he dosyncrac producon gap componens dependng on he exen by whch naonal erm spreads are drven by counry-specfc or global macroeconomc dynamcs. Fnally, he resuls under column (III show ha conrollng for he log dvdend-prce rao does no aler any of he conclusons drawn above. In conras o he erm spread, he dvdend-prce rao leaves he sascal sgnfcance of he common componen n he Canadan producon gap unaffeced. The dvdend-prce rao self s no sgnfcanly explanng he sock marke excess reurns under sudy. Snce he erm spread seems o be beer sued as conrol n he forecas regressons, he subsequence of he paper makes no furher use of he dvdend-prce rao as conrol varable. [abou here Table 3] 14 13

17 3. Sock excess reurn forecas regressons: subsample analyss The resuls presened so far hghlgh ha a common componen n naonal producon gaps raonalzes her explanaory power for sock marke excess reurns one monh ahead. The gap, however, s measured as a devaon of an ndusral producon ndex from a lnear and a quadrac me rend over he full sample perod. I mgh be he case ha he man resuls depend on he parculares of he sample perod. A comparson of he nernaonal evdence provded n Cooper and Presley (009 and he rerun dsplayed n secon 3.1 could rase concerns n hs respec. The nernaonal evdence n Cooper and Presley (009 s less srong n erms of sascal sgnfcance han he reruns of her orgnal regressons presened n hs paper. Ths s ceranly due o he fac ha he Cooper and Presley (009 sample perod ends n 005 whereas hs paper ncludes fve addonal years of daa ncludng he grea recesson and hence a maeral devaon of ndusral producon n he G7 counres from rend. To gauge he mpac of he parcular sample perod on he man conclusons of hs paper, I spl he sample perod no wo halves. The frs subsample perod runs from January 1970 o June The second subsample spans he perod from July 1990 o February 011. I hen run equaon (1 o oban he producon gaps for he parcular subsample perod and rerun he forecas regresson (9 for he wo subsample perods. Table 4 summarzes he resuls. Panel A of able 4 provdes he forecas regresson resuls for he frs, early subsample perod. In erms of sascal sgnfcance of he common producon gap componen s predcve power he resuls are slghly weaker han for he full sample perod. For Canadan and Ialan sock marke excess reurns he common producon gap componen exhbs no sascally sgnfcan explanaory power. For France, he esmae s margnally nsgnfcan a he 90% confdence level. Tme varaon n Japanese, Brsh and Amercan sock marke excess reurns, however, appears o be sgnfcanly explaned by he common producon gap componen. The explanaory power of he respecve producon gap componens for hs 15 14

18 subsample perod s comparable wh ha over he full sample perod. Ths s also rue for German sock excess reurns bu only a he 90% confdence level accordng o he Valkanov (003 correced -sascs. In he case of Germany, he dosyncrac componen also reveals some explanaory power for me varaon n he naonal sock marke n hs early subsample perod. Panel B of able 4 dsplays he forecas regresson resuls for he more recen subsample perod. The sascal sgnfcance of he common producon gap componen s forecas ably for he German, French and Japanese sock marke excess reurns deeroraes o sgnfcance levels below 95%. By conras, he Canadan sock marke excess reurn urns ou o be sgnfcanly explaned by he common producon gap componen as do he Brsh and Amercan sock marke excess reurns. In hs subsample perod, boh he common and he dosyncrac producon gap componen sgnfcanly drve he Ialan sock marke. In sum, he parcular sample perod for whch he producon gap and s common and dosyncrac componen are calculaed ceranly maers. However, he general concluson ha he common componen n naonal producon gaps s a sgnfcan explanaory varable of me varaon n naonal sock marke excess reurns perans o boh subsample perods. [abou here Table 4] 3.3 Sock excess reurn forecas regressons: Long-horzon forecass Macroeconomcally founded predcors of sock marke reurns ypcally dsplay her greaes explanaory power a busness cycle frequency forecas horzons (e.g. Cooper and Presley, 009; Hoffmann, 011; Leau and Ludvgson, 001; Lusg and van Neuwerburgh, 005; Pazzes e al., 007; angvd, 006; Sanos and Verones, 006. Ths s also suggesed by heorecal models ha movae me-varyng excess reurns on sock markes wh mevaraon n rsk averson over he busness cycle (e.g. Campbell and Cochrane, 1999; Consanndes, 1990; Consanndes and Duffe, 1996; Heaon and Lucas, 000 a, b; Yogo,

19 Inference from long-horzon regresson esmaes should noneheless be nerpreed wh healhy scepcsm because he usual seup of hese regressons ncludes a relavely small sample sze, perssen regressors and concaenaed one-perod logarhmc reurns o oban long-horzon reurns. Valkanov (003 and he leraure surveyed heren provde an accoun of he poenal economerc pfalls n such a seng. However, Hodrck (199 shows ha relavely lle bu sgnfcan predcve power n he shor erm s conssen wh a large amoun of predcably a long forecas horzons. Hence, he one-monh ahead forecas regressons already provde he proof of he n-sample forecas ably of he common producon gap componens. The one-monh regressons have also aken no accoun ha he regressors are generaed n a frs sage. Ths secon herefore uses long-horzon forecass prmarly o assess f he mporance of he common or dosyncrac producon gap componens changes wh he forecas horzon. I assess hs ssue hrough he followng regresson e,, h common,, h do, r, + h = + β1 gap + β gap + ν, + h α (11 where e r, h, + s he log sock marke excess reurn of counry over he forecas horzon h. The forecas horzon s n monhs. Table 5 summarzes he resuls for forecas horzons of 1, 4 and 36 monhs. Newey-Wes (Newey and Wes, 1987 correced -sascs appear below he esmaes n parenhess and he asersk denoes sgnfcance a 95% confdence level by boh Newey-Wes and Valkanov (003 correced -sascs. The sample perod runs from January 1970 o February 011. Furhermore, snce no only poenal bas n he sandard errors of he esmaes bu also n he esmaes hemselves makes nference from long-horzon regressons dffcul, hs paper also provdes long-horzon esmaes and sascs mpled by he onemonh ahead regresson under he null of no predcably (Boudoukh e al., 008. Boudoukh e al. (008 emphasze ha he paern n pon esmaes and ha are ypcally repored n long-horzon regressons are perfecly conssen wh he vew ha here s no reurn 17 16

20 predcably a all. They show ha pon esmaes a forecas horzon k mpled by acual 1 one-perod coeffcens, ˆβ, and he auocorrelaon of a gven regressor, ρ, under he null of no predcably obeys ˆ k ˆ ρ(1 ρ ( β β 1 β 1 ρ E = + k 1 1 ˆ 1 (1 and he sasc accordngly 1 k (1 ρ ρ E( k 1 ρ = k 1 (13 I repor hese sascs n able 5 under he headng mpled esmaes. The long-horzon forecass reveal wo major nsghs. Frs, n lne wh heory and earler evdence, he predcve power of he producon gap componens ncreases wh he forecas horzon. A he 36-monh horzon almos 30% of he me varaon n he French and Japanese sock marke excess reurns s explaned by he common producon gap. For he oher counres he explanaory power ranges beween 1% and 17% a ha horzon. Second, s he common producon gap componen ha drves he predcve power of producon gaps a all forecas horzons. The mporance of he dosyncrac componen for he Ialan sock marke reurn vsble n able 3 vanshes n he long-horzon forecass. The sandard error correcons (Valkanov, 003 and he mpled esmaes under he null of no predcably (Boudoukh e al., 008 mos of he me delver a conssen pcure wh regard o he sgnfcance of he long-horzon esmaes. Consder e.g. France a he 4-monh and a he 36-monh forecas horzon. A he 4-monh horzon, he convenonal Newey-Wes correced -sascs leave he mpresson of sgnfcan predcably of he common producon gap. However, he Valkanonv-correced -sascs sugges he oppose as do he mpled esmaes accordng o Boudoukh e al. (008. The pon esmaes and he mpled 18 17