Why Are Stock Market Returns Correlated with Future Economic Activities?

Stock price has been found to provide important information about future economic activities. Fama (1981), Fischer and Merton (1984), and Barro (1990), among many others, document a positive relation between stock market return and subsequent growth in investment and output. These findings are consistent with rational expectations asset pricing models, in which stock price is equal to the sum of discounted future cash flows or dividends. An unexpected increase in the stock price indicates that (i) future dividend growth is higher and/or (ii) future discount rates are lower than previously anticipated. Given that the dividend is an important component of gross domestic product (GDP) and is also likely to be positively correlated with the other components of GDP, the stock price increase may merely reflect higher expected future output. On the other hand, lower discount rates are associated with higher investment and, therefore, higher output.1 Moreover, recognizing a timevarying risk premium, Lettau and Ludvigson (2001b) show that the q theory of investment implies an important relation between the expected stock market return and investment. That is, lower expected stock market return implies lower future stock price and higher future capital cost; accordingly, investment falls over long horizons. The analysis above shows that stock returns are correlated with future economic activities through different channels. In this paper, I address the relative importance of these mechanisms by using Campbell and Shiller’s (1988) method to decompose excess stock market return, eM,t, into three parts: expected return, Et –1eM,t; a shock to the expected future return, ;