Hostname: page-component-78c5997874-j824f Total loading time: 0 Render date: 2024-11-05T04:43:59.977Z Has data issue: false hasContentIssue false

Davids, Goliaths, and Business Cycles

Published online by Cambridge University Press:  27 December 2017

Abstract

We show that a simple, intuitive variable, Goliath versus David (GVD), reflects time variation in discount rates related to changes in aggregate business conditions. GVD is the annual change in the weight of the largest 250 firms in the aggregate stock market and is motivated by research that shows that small firms are more severely impacted than large firms by economic shocks due to differences in access to external finance. We find that GVD is the best single predictor of out-of-sample market returns among traditional predictors, predicting quarterly market returns with an out-of-sample R2 of 6.3% in the 1976–2011 evaluation period.

Type
Research Article
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2017 

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

Footnotes

1

We give special thanks to Hendrik Bessembinder (the editor) and Jeffrey Pontiff (associate editor and referee) for many helpful suggestions. We also thank Caio de Almeida, Heitor Almeida, Kerry Back, Murillo Campello, Miguel Ferreira, Wayne Ferson, Michael Lemmon, Michael McCracken, Brad Paye, Sergei Sarkissian, Allan Timmermann, Pietro Veronesi, James Weston, our colleagues at Rice University, as well as seminar participants at the 2012 Brazilian Finance Association meeting, the 2013 World Finance Conference, the 2013 European Financial Management Association meeting, the 2014 City University of Hong Kong finance conference, Erasmus University Rotterdam, Tilburg University, University of New South Wales, University of Sydney, and University of Technology Sydney for helpful comments. All remaining errors are our own.

References

Amihud, Y., and Hurvich, C. M.. “Predictive Regressions: A Reduced-Bias Estimation Method.” Journal of Financial and Quantitative Analysis, 39 (2004), 813841.Google Scholar
Ang, A., and Bekaert, G.. “Stock Return Predictability: Is It There?Review of Financial Studies, 20 (2007), 651707.Google Scholar
Bernanke, B., and Gertler, M.. “Agency Costs, Net Worth and Business Cycle Fluctuations.” American Economic Review, 79 (1989), 14131.Google Scholar
Bernanke, B., and Gertler, M.. “Financial Fragility and Economic Performance.” Quarterly Journal of Economics, 105 (1990), 87114.Google Scholar
Bernanke, B.; Gertler, M.; and Gilchrist, S.. “The Financial Accelerator and the Flight to Quality.” Review of Economics and Statistics, 78 (1996), 115.CrossRefGoogle Scholar
Bernanke, B. S.; Gertler, M.; and Gilchrist, S.. “The Financial Accelerator in a Quantitative Business Cycle Framework.” In Handbook of Macroeconomics, Vol. 1, Taylor, J. B. and Woodford, M., eds. Amsterdam, The Netherlands: Elsevier Science B.V. (1999), 13411393.Google Scholar
Boudoukh, J.; Michaely, R.; Richardson, M.; and Roberts, M. R.. “On the Importance of Measuring Payout Yield: Implications for Empirical Asset Pricing.” Journal of Finance, 62 (2007), 877915.Google Scholar
Caballero, R. J., and Krishnamurthy, A.. “Collective Risk Management in a Flight to Quality Episode.” Journal of Finance, 63 (2008), 21952230.CrossRefGoogle Scholar
Campbell, J. Y.Stock Returns and the Term Structure.” Journal of Financial Economics, 18 (1987), 373399.Google Scholar
Campbell, J. Y., and Cochrane, J. H.. “By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior.” Journal of Political Economy, 107 (1999), 205251.CrossRefGoogle Scholar
Campbell, J. Y., and Shiller, R. R.. “The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors.” Review of Financial Studies, 1 (1988a), 195228.Google Scholar
Campbell, J. Y., and Shiller, R. R.. “Stock Prices, Earnings, and Expected Dividends.” Journal of Finance, 43 (1988b), 661676.Google Scholar
Campbell, J. Y., and Thompson, S. B.. “Predicting Excess Stock Returns Out of Sample: Can Anything Beat the Historical Average?Review of Financial Studies, 21 (2008), 15091531.Google Scholar
Campbell, J. Y., and Vuolteenaho, T.. “Bad Beta, Good Beta.” American Economic Review, 94 (2004), 12491275.Google Scholar
Cochrane, J. H.New Facts in Finance.” Economic Perspectives, 23 (1999), 3658.Google Scholar
Cochrane, J. H. Asset Pricing. Princeton, NJ: Princeton University (2001).Google Scholar
Cochrane, J. H.Production-Based Asset Pricing and the Link between Stock Returns and Economic Fluctuations.” Journal of Finance, 46 (1991), 209237.Google Scholar
Cochrane, J. H., and Piazzesi, M.. “Bond Risk Premia.” American Economic Review, 94 (2005), 138160.Google Scholar
Connolly, R., and Stivers, C.. “Momentum and Reversals in Equity-Index Returns during Periods of Abnormal Turnover and Return Dispersion.” Journal of Finance, 58 (2003), 15211555.Google Scholar
Covas, F., and Den Haan, W. J.. “The Cyclical Behavior of Debt and Equity Finance.” American Economic Review, 101 (2011), 877899.Google Scholar
Fama, E. F., and French, K. R.. “Dividend Yields and Expected Stock Returns.” Journal of Financial Economics, 22 (1988), 325.Google Scholar
Fama, E. F., and French, K. R.. “Business Conditions and Expected Returns on Stocks and Bonds.” Journal of Financial Economics, 25 (1989), 2349.Google Scholar
Fama, E. F., and French, K. R.. “Multifactor Explanations of Asset Pricing Anomalies.” Journal of Finance, 51 (1996), 5584.Google Scholar
Fama, E. F., and French, K. R.. “New Lists: Fundamentals and Survival Rates.” Journal of Financial Economics, 73 (2004), 229269.Google Scholar
Ferreira, M. A., and Santa-Clara, P.. “Forecasting Stock Market Returns: The Sum of the Parts Is More Than the Whole.” Journal of Financial Economics, 100 (2011), 514537.Google Scholar
Ferson, W. E.; Sarkissian, S.; and Simin, T.. “Spurious Regressions in Financial Economics.” Journal of Finance, 63 (2003), 13931414.Google Scholar
Fogel, K.; Morck, R.; and Yeung, B.. “Big Business Stability and Economic Growth: Is What’s Good for General Motors Good for America?Journal of Financial Economics, 89 (2008), 83108.Google Scholar
Gertler, M., and Gilchrist, S.. “Monetary Policy, Business Cycles, and the Behavior of Small Manufacturing Firms.” Quarterly Journal of Economics, 109 (1994), 309340.Google Scholar
Goyal, A., and Welch, I.. “A Comprehensive Look at the Empirical Performance of Equity Premium Prediction.” Review of Financial Studies, 21 (2008), 14551508.Google Scholar
Hall, P.; Horowitz, J. L.; and Jing, B.-Y.. “On Blocking Rules for the Bootstrap with Dependent Data.” Biometrika, 82 (1995), 561574.Google Scholar
Hansen, P. R., and Timmermann, A.. “Choice of Sample Split in Out-of-Sample Forecast Evaluation.” European University Institute Working Paper ECO 2012/10 (2012).Google Scholar
Henkel, S. J.; Martin, J. S.; and Nardari, F.. “Time-Varying Short-Horizon Predictability.” Journal of Financial Economics, 99 (2011), 560580.Google Scholar
Kelly, B., and Pruitt, S.. “Market Expectations in the Cross Section of Present Values.” Journal of Finance, 68 (2013), 17211756.Google Scholar
Kendall, M.A Note on Bias in the Estimation of Autocorrelation.” Biometrika, 41 (1954), 403404.Google Scholar
Kiyotaki, N., and Moore, J.. “Credit Cycles.” Journal of Political Economy, 105 (1997), 211248.Google Scholar
Lettau, M., and Lydvigson, S.. “Consumption, Aggregate Wealth, and Expected Stock Returns.” Journal of Finance, 56 (2001), 815849.Google Scholar
Lettau, M., and Wachter, J. A.. “Why Is Long-Horizon Equity Less Risky? A Duration-Based Explanation of the Value Premium.” Journal of Finance, 62 (2007), 5592.Google Scholar
Liang, C. Y. C.; McLean, R. D.; and Zhao, M.. “Creative Destruction and Finance: Evidence from the Last Half Century.” Working Paper, University of Alberta (2011).Google Scholar
Lo, A., and MacKinlay, A.. “When Are Contrarian Profits Due to Stock Market Overreaction?Review of Financial Studies, 3 (1990), 175205.Google Scholar
McCracken, M.Asymptotics for Out-of-Sample Tests of Granger Causality.” Journal of Econometrics, 140 (2007), 719752.Google Scholar
McLean, R. D., and Pontiff, J.. “Does Academic Research Destroy Stock Return Predictability?Journal of Finance, 71 (2016), 532.Google Scholar
Menzly, L.; Santos, T.; and Veronesi, P.. “Understanding Predictability.” Journal of Political Economy, 112 (2004), 147.Google Scholar
Newey, W., and West, K.. “A Simple, Positive Semi-Definite, Heteroskedasticity and Autocorrelation Consistent Covariance Matrix.” Econometrica, 55 (1987), 703708.Google Scholar
Perez-Quiros, G., and Timmermann, A.. “Firm Size and Cyclical Variations in Stock Returns.” Journal of Finance, 55 (2000), 12291262.Google Scholar
Polk, C.; Thompson, S.; and Vuolteenaho, T.. “Cross-Sectional Forecasts of the Equity Premium.” Journal of Financial Economics, 81 (2006), 101141.Google Scholar
Pontiff, J., and Schall, L. D.. “Book-to-Market Ratios as Predictors of Market Returns.” Journal of Financial Economics, 49 (1998), 141160.Google Scholar
Pontiff, J., and Woodgate, A.. “Share Issuance and Cross-Sectional Returns.” Journal of Finance, 49 (2008), 141160.Google Scholar
Rapach, D. E.; Strauss, J. K.; and Zhou, G.. “Out-of-Sample Equity Premium Prediction: Combination Forecasts and Links to the Real Economy.” Review of Financial Studies, 23 (2010), 821862.CrossRefGoogle Scholar
Schwert, G. W.Stock Returns and Real Activity: A Century of Evidence.” Journal of Finance, 45 (1990), 12371257.Google Scholar
Stambaugh, R. F.Predictive Regressions.” Journal of Financial Economics, 54 (1999), 375421.Google Scholar
Subrahmanyam, A., and Titman, S.. “Financial Market Shocks and the Macroeconomy.” Review of Financial Studies, 26 (2013), 26872717.CrossRefGoogle Scholar