Time Varying Risk Premia and the Output Gap

The output gap, a production based macroeconomic variable, is a strong predictor of US stock returns. It is a prime business cycle indicator that does not include the level of market prices, thus removing any suspicion that returns are forecastable due to a quot;fadquot; in prices being washed away. The output gap forecasts returns both in-sample and out-of-sample and it is robust to a host of checks. We show that the output gap also has predictive power for excess stock returns in other G7 countries and US excess bond returns