The output gap and stock returns: Do cyclical fluctuations predict portfolio returns?

This study examines whether the output gap leads portfolio stock returns. The paper conducts in-sample and out-of-sample forecasting of US stock portfolios formed on the basis of size and value. First, the paper finds cross-sectional portfolios are predictable in-sample by the output gap. Out-of-sample evidence is weaker but still generally supports the finding that the historical average benchmark can be beaten. Secondly and most importantly, we find mixed evidence that the Fama–French factor mimicking portfolios can be forecasted by the output gap. In particular, there is some out-of-sample predictability of the size effect (SMB) suggesting this lags the output gap. However, the output gap, a key business cycle indicator, cannot predict the value effect (HML) either in-sample or out-of-sample. Our results add to the prior literature which finds that the factor mimicking returns are related contemporaneously (Petkova and Zhang, 2005) or lead (Liew and Vassalou, 2000) economic indicators.