Short- and Long-Run Business Conditions and Expected Returns

Numerous studies argue that the market risk premium is associated with economic conditions and show that proxies for business conditions indeed predict aggregate market returns. By directly estimating short- and long-run expected economic growth, we show that short-run expected economic growth is negatively related to future returns, whereas long-run expected economic growth is positively related to aggregate market returns. At an annual horizon, short- and long-run expected growth can jointly predict aggregate excess returns with an R-sqr of 17-19%. Our findings indicate that the risk premium has both high- and low-frequency fluctuations and highlight the importance of distinguishing short- and long-run economic growth in macro asset pricing models