The world business cycle and expected returns

Abstract

We study the predictability of stock returns using a pure macroeconomic mea- sure of the world business cycle, namely the world's capital to output ratio. This variable tracks variation in expected stock returns in a group of the major industrial economies in the presence of world nancial market based predictor variables. The world's capi- tal to output ratio exhibits strong out-of-sample predictive power in almost all countries studied. This is in contrast to nancial market based variables that almost never have out-of-sample forecasting power. Using the stock return predictability that we uncover, we nd that international versions of conditional asset pricing models perform well. The world capital to output ratio also predicts bond returns, interest rate changes and credit spreads. The results highlight the importance of world business conditions for nancial markets.