Should Equity Investors Hope for Good or Bad Economic Forecasts?

Do forecasts for the economy at large predict returns for stock investors? In the September 2005 version of their paper entitled “Stock Returns and Expected Business Conditions: Half a Century of Direct Evidence”, Sean Campbell and Francis Diebold characterize the relationship between expected business conditions (predictions of real growth in GDP six and 12 months ahead) and stock returns. Using half a century (1952-2002) of Livingston Survey expected business conditions results and corresponding measures of expected stock returns, they conclude that:

• On average, the Livingston survey forecasts for real GDP growth are reasonably accurate.
• When economists expect good (bad) business conditions over the next six to 18 months, financial measures predict low (high) returns from stocks.
• Standard measures of expected stock returns (the dividend yield, the default premium, and the term premium) are probably noisy approximations of expected business conditions.
• Expected business conditions are one of the most highly significant predictors of volatility in stock returns, with low (high) growth expectations forecasting high (low) future volatility. Expected business conditions probably measure risk, appropriately rewarded inversely by investment returns.

In summary, equity investors should be contrarian when considering economic forecasts. Bad is good.