Are equity risk factors leading indicators for economic growth?

In the present paper we examine the information content of the equity risk factors that explain cross variation of stock returns, in predicting future macroeconomic growth. For the first time we incorporate in the analysis the two newly developed risk factors by Fama and French, that account for the operating profitability and the asset growth of companies, thus, providing important insights in the relationship between risk factors and the business cycle. Operating profitability is measured by the operating profit margin of sample companies. The main part of the methodology involved the performance of a stepwise regression analysis of future macroeconomic growth, as proxied by GDP growth against the lagged returns of the six risk factors (market risk premium, size, value, momentum, asset growth and operating profitability). That information was collected from the Thompson Reuters Eikon database. The results of the regression analysis were further validated with the use, for the first time, of Granger causality tests and out-of-sample dynamic forecasting. The empirical results indicated that the two new risk factors contain strong, stable and statistically significant incremental information concerning future macroeconomic growth. Furthermore, the market risk premium had a robust positive relationship with future economic growth, while the size, value and momentum risk factor showed a negative and statistically significant relationship with future economic growth. Overall, our results suggest that information from stock prices can be used as leading indicators for the prediction of the future state of the business cycle. Specifically, the risk factors that are used as proxies for explaining the future equity returns can also be used as indicators for macroeconomic growth.