Nosing Out the News in Financial Asset Returns
The notion that financial asset returns are useful for predicting the future course of the economy is widespread. But detailed analyses provide little support for financial markets ability to reveal future economic activity. Even though the evidence on various indicators used by different researchers is mixed, a recent Economic Review article explores the notion that financial markets reveal useful information about future economic activity.
Authors Gerald P. Dwyer Jr. and Cesare Robotti examine and answer two questions: First, what is a good way of extracting information about future economic activity from asset prices? Second, do financial asset returns help predict economic activity over horizons from one month to five years?
To determine whether news of an assets excess return can reveal information about unexpected economic activity, the authors construct a method of extracting the news about future economic activity from returns on financial assets. The authors use linear regressions to relate the unexpected parts of economic activity and the assets return to actual economic activity and the actual return on an asset.
The evidence in the article shows that movements in financial markets do presage developments in the economy. The authors find that movements in the overall stock market and bond returns are the most important financial indicators. It remains to be seen whether those indicators hold up to variations in technique or the passage of time.