Predicting Stock Returns in an Efficient Market

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. A RAPIDLY GROWING BODY of research documents forecastable components in security returns. The extent of predictability is a function of the return horizon, with predictable variation in aggregate returns ranging from around 3 percent for shorter horizons to above 25 percent for longer horizons. One of the most successful attempts in predicting security returns is Fama and French (1988b). Other papers demonstrating predictability are, for example, Fama and Schwert (1977), Keim and Stambaugh (1986), Campbell (1987), French, Schwert, and Stambaugh (1987), Campbell and Shiller (1988), and Lo and MacKinlay (1988).Potential explanations for the predictability of returns fall, primarily, into two areas: 1) some form of general or limited irrationality, such as fads, speculative bubbles, or noise trading or 2) some form of general equilibrium model that provides for variation in real rates of return over time. Although substantial literature exists debating the "irrational" alternative (see Summers (1986), Poterba and Summers (1988), or West (1988)), we are not aware of work that provides an explanation in the context of a parsimonious and empirically robust general equilibrium model.It is important to emphasize, as Fama and French (1988a), and others have noted, that, in the context of intertemporal models, predictability is not necessarily inconsistent with the concept of market efficiency. The purpose of this paper is to present a general equilibrium theory relating returns on financial assets to macroeconomic fluctuations in a context that is consistent with efficient markets in that no excess-profit opportunities are available. Accordingly, we show that, within an efficient market framework, stock prices need not follow a for helpful comments. In addition, the paper benefited from discussions with seminar participants at the Federal Reserve Bank of New York, Michigan State University, Texas A&M University, and University of Notre Dame and substantive comments of an anonymous referee. 1110The Journal of Finance random walk and that changes in the equilibrium return on stocks can be predicted to the extent that there is predictability in aggregate output.The intuition underlying our theoretical model arises from consumption smoothing by investors. Consumption opportunities are linked to output, and, consistent with conventional macroeconomic models, output is seria...

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