Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives. The following article originally appeared on ETF.COM here.

There is a large body of literature on stock return predictability, with most predictive variables being financial variables such as the earnings yield (E/P), dividend yield (D/P) and the Shiller CAPE 10 ratio. However, there is not much evidence in favor of returns being predictable from aggregate consumption data. Stig Vinther Moller contributes to the literature on expected equity returns with his November 2017 study, “Cyclical Consumption and Time-Variation in Expected Stock Returns.”

Cyclical consumption and excess returns

The objective of the study was to determine whether movements in expected stock returns have any direct relation to cyclical consumption (consumption varies with the state of economy) and, if so, whether cyclical consumption contains information about expected stock returns that isn’t already captured by existing predictive variables. Moller found that predictive regressions of excess stock returns on cyclical consumption (CC) show there is a strong negative relation between it and future excess stock returns.

This is consistent with economic theory, in which expected returns are driven by the cyclical time-variation in the price of consumption risk – during bad economic times (such as during the great financial crisis), investors demand a larger risk premium.

The implication is that expected excess stock returns are high when CC is low during cyclical downturns. On the other hand, expected excess stock returns are low when CC is high during cyclical upswings. Following is a summary of Moller’s other findings:

  • When using real-time data, CC strongly outperforms the historical mean return as a predictor of future returns.
  • CC contains considerable information about future stock returns not already explained by labor capital and financial wealth. Together, these variables explain as much as about 20% of the variation in one-year-ahead excess stock returns.