What does the tail of the distribution of current stock prices tell us about future economic activity?

Abstract

This paper proposes three leading indicators of economic conditions estimated using current stock returns. The assumption underlying our approach is that current asset prices reflect all the available information about future states of economy. Each of the proposed indicators is related to the tail of the cross‐sectional distribution of stock returns. The results show that the leading indicators have strong correlation with future economic conditions and usually make better out‐of‐sample predictions than two traditional competitors (random walk and the average of previous observations). Furthermore, quantile regressions reveal that the leading indicators have strong connections with low future economic activity.

Moments of cross‐sectional stock market returns and the German business cycle

“…This concerns, in particular, the explanatory power of the regression results, which are significantly lower for both regressions with and without additional control variables. The same holds for the comparison in terms of cross‐sectional skewness with the results for Vicente and Araujo (2018) cross‐sectional tail risk measures for Brazil.…”

“…A possible explanation for the differences in the results from those of Ferreira (2022) for the US and those of Vicente and Araujo (2018) for Brazil is likely the marked differences in the financial systems between Germany on the one hand and the US and Brazil on the other hand. For example, Lee (2012) examined the relative merits of bank-based and marketbased financial systems in promoting long-term economic growth.…”

“…Primarily, our paper investigates the cross-sectional skewness of stock returns as a leading indicator of the business cycle. In this context, Vicente and Araujo (2018) propose three leading indicators related to the tail of the cross-sectional distribution of stock returns: (1) the left tail percentile of stock returns at each point in time; (2) the expected shortfall of the cross-sectional stock returns; (3) an indicator that uses the extreme value theory to model the behaviour of asset prices, according to Kelly and Jiang (2014). For Brazil, they find evidence that the three leading indicators have a high correlation with future economic conditions, and that the indicators usually make better out-of-sample predictions than the random walk and the average of previous observations.…”

“…To the best of our knowledge, this is the first paper to investigate whether cross‐sectional moments of stock market returns may provide information about the future prospects of the German business cycle. With the cross‐sectional skewness, we continue to consider a measure that is currently gaining in importance in the literature (Ferreira, 2022; Vicente & Araujo, 2018). Therefore, we look at a wider range of information that is helpful in the context of extreme movements in the form of tail risks.…”

The Interconnectedness of Stock Prices, Money, and Credit Across Time and Frequency From 1970 to 2016

“…Finally, stock price dynamics can also indicate increasing concerns about the state of the economy, potential problems in credit markets (Bernanke, 2008) and risks to financial fragility (Chen et al, 2021). Vicente and Araujo (2018) evidence that their leading indicators based on current stock returns have strong correlation with future economic conditions. Recently, Davis et al (2022) by analysing 35 sample countries argued that stock prices signalled the severity and the timing of the collapses of those countries' economic activity because of the Coronavirus pandemic.…”