Time-Varying Risk Premiums and the Output Gap

The output gap, a production-based macroeconomic variable, is a strong predictor of U.S. 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 "fad" 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 U.S. excess bond returns. The Author 2008. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org, Oxford University Press.