International Stock Return Predictability and Business-Cycle Fluctuations

We analyze stock return predictability for 12 industrialized countries over the postwar period. We focus on out-of-sample predictability based on a forecast combination approach that incorporates information from a host of potential predictors, including economic variables from the literature and lagged international stock returns. Combination forecasts of stock returns generate statistically and economically significant gains relative to historical average benchmark forecasts consistently over the postwar period. Moreover, stock return predictability is often markedly enhanced during business-cycle recessions. This strongly links stock return predictability in industrialized countries with business-cycle fluctuations and is consistent with increased risk aversion on the part of economic agents during downturns. Interestingly, we also find that while lagged stock returns from all 12 countries are unimportant individually and collectively for forecasting U.S. returns, lagged international returns--especially lagged U.S. returns--are important for forecasting returns in the other 11 countries we consider. This points to information frictions in international equity markets: investors focus more on the U.S. equity market, creating a slower diffusion of information on macroeconomic fundamentals to other countries.