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Do stocks effectively predict recessions? –


Late Recessions: Stocks and the Business Cycle

  • Gomez-Kram
  • Journal of Finance, 2022 year
  • A version of this document can be found here here
  • Want to read our summaries of academic finance papers? Check out ours Academic Research Insight category

What are the research questions?

There is a wealth of literature on the relationship between the business cycle and future stock returns. The traditional view is that stock prices are rational to immediately reflect investors’ expectations of future economic activity, and that expected excess stock returns are positive, time-varying, and exhibit countercyclical behavior.

The author asks the following question:

  1. Do stock returns effectively account for fluctuations in the business cycle?

What is academic information?

Using real-time macroeconomic and financial data to identify real-time business cycle inflection points, the author finds:

  1. NO, stock prices are lagging behind information that signals the onset of a recession. In fact, they are predictably negative for several months after a recession begins, before rising to a consistently above-average level.
  2. Profitability shows significant dynamics during recessions, while during expansions they show the slight reversals expected from changes in the discount rate.
  3. A trading strategy that uses the above findings delivers significant risk-adjusted returns: for the overall market, it earns an annualized alpha of 5.4%, increases Sharpe ratios by 30% compared to a fully invested buy-and-hold approach, and delivers a significant monthly out-of-sample R2 statistic of 1.7%.

Why is this important?

From the perspective of market participants, the above pattern of results suggests that investors can profit by selling early in a recession and increasing risk a few months later. From a risk perspective, the empirical findings present a puzzle because it is difficult to explain negative average excess returns in any rational equilibrium model. Compounding the puzzle is the fact that these negative returns occur during bad macroeconomic times, precisely when risk-based theories typically suggest that risk compensation should be positive and high. Instead, the author argues that the pattern appears more consistent with the idea that investors are late in responding to macroeconomic news that signals the onset of a recession.

The most important diagram from paper:

The results are hypothetical results and are NOT indicative of future results and are NOT representative of the returns any investor may actually achieve. The Indices are not managed, reflect no management or trading fees, and cannot be invested directly in the Index.


I show that the state of the business cycle is much more informative about expected stock returns than
previously recognized. I identify business cycle turning points by estimating a state space model
using real-time macroeconomic and financial data. I believe the return is predictably negative
during the first 4-6 months after the recession begins, and only then become high. Moreover,
yields show significant momentum during recessions, while during expansions they show a mild
reversals expected from a change in the discount rate. A market timing strategy that makes the most of it
the dependence of these returns on the business cycle leads to a 60% increase in the “buy and hold” Sharpe ratio
and significantly outperforms popular synchronization strategies in out-of-sample tests. Unlike
In the previous literature, predictability is mainly driven by macro variables. Using the investor’s forecast
surveys, I show that my findings are consistent with investors’ slow response to recessions.

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