Business Cycles And Stock Market Returns: Evidence Using Industry‐Based Portfolios

Much evidence has emerged recently that suggests stock returns are predictable. In representative agent consumption‐based asset pricing models, asset returns are related to aggregate output and consumption through changes in the intertemporal marginal rate of substitution. An alternative view is that the amount of variation required in the intertemporal marginal rate of substitution is too large to be rationally explained. We shed further light on this debate by investigating whether the stock returns of certain sectors of the economy can predict future market returns even after controlling for the information contained in the aggregate market index. In the consumption‐based models, aggregate output and consumption affect the discount rates of all assets synchronously; no particular sectoral return should have any more predictive ability than the others. We find evidence that the stock returns of five industry‐based portfolios have significant information about future market returns that is not in the market index. This stylized empirical result is not consonant with existing models relating output to stock returns.