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Vol. 84, No. 2
Posted 2002-03-01

Why Are Stock Market Returns Correlated with Future Economic Activities?

by Hui Guo

Stock price, because it is a forward-looking variable, forecasts economic activities. An unexpected increase in stock price reflects that (i) future dividend growth is higher and/or (ii) future discount rates are lower than previously anticipated; therefore, the increase predicts higher output and investment. As well, other studies argue for an important relation between the expected stock market return and investment. In this paper, Hui Guo analyzes the relative importance of these mechanisms by using Campbell and Shiller’s (1988) method to decompose stock market return into three parts: expected return, a shock to the expected future return, and a shock to the expected future dividend growth. Contrary to the conventional wisdom, the author finds that dividend shocks are a rather weak predictor of future economic activities. Moreover, the expected return and shocks to the expected future return display different predictive patterns. The results shown here, collectively, explain why the forecasting power of stock market return is rather limited.

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