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The nonlinear multidimensional relationship between stock returns and the macroeconomy

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  • Pian Chen
  • Aaron Smith

Abstract

We use nonparametric dimension-reduction methods to extract from a set of 15 macroeconomic variables the risk factors that are priced in the stock market. The dominant factor moves with the business cycle but, because it is a nonlinear function of observed macroeconomic variables, it captures a rich set of interactions. Low-credit risk and low-inflationary expectations have a greater positive effect on stock returns when leading macroeconomic indicators are high relative to current economic activity, i.e. early in the business cycle as the economy emerges from recession. High-stock returns also arise in periods when the economy is booming relative to its leading indicators, but such periods tend to portend crashes.

Suggested Citation

  • Pian Chen & Aaron Smith, 2013. "The nonlinear multidimensional relationship between stock returns and the macroeconomy," Applied Economics, Taylor & Francis Journals, vol. 45(35), pages 4985-4999, December.
    • Handle: RePEc:taf:applec:v:45:y:2013:i:35:p:4985-4999
    DOI: 10.1080/00036846.2013.806785
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