Stock Market Returns, Volatility, and Future Output

Stock market volatility is the systematic risk faced by investors who hold a market portfolio (e.g., a stock market index fund). Schwert (1989b) has undertaken an extensive study of stock market volatility, using historical data back to the 19th century. Some of his major findings are illustrated in Figure 1, which plots quarterly stock market volatility for the post-World War II period.1 The figure shows that volatility moves countercyclically, exhibiting spikes during recessions. Also, stock market volatility tends to increase dramatically during financial crises (such as the 1987 stock market crash, the 1997 East Asia crisis, and the 1998 Russian bond default) and periods of uncertainty (such as the 1962 Cuban missile crisis). Moreover, volatility, once risen, shows some inertia in that it reverts only slowly to its previous, low level. Although the causes of stock market volatility are not well understood, some authors suggest that elevated stock market volatility might reduce future economic activity.2 Schwert (1989a) argues that stock market volatility, by reflecting uncertainty about future cash flows and discount rates, provides important information about future economic activity. Campbell et al. (2001), citing work by Lilien (1982), reason that stock market volatility is related to structural change in the economy. Structural change consumes resources, which depresses gross domestic product (GDP) growth. Another link between stock market volatility and output rests on a cost-of-capital channel. That is, an increase in stock market volatility raises the compensation that shareholders demand for bearing systematic risk. The higher expected return leads to the higher cost of equity capital in the corporate sector, which reduces investment and output. Consistent with these hypotheses about the link between stock market volatility and economic activity, Campbell et al. (2001) show that—after controlling for the lagged dependent variable—stock market volatility has significant predictive power for real GDP growth. Moreover, these authors also show that stock market volatility drives out returns in forecasting output. This finding deserves discussion. Finance theory suggests that stock market returns rather than volatility have predictive power for investment and output because stock market returns are a forward-looking variable that incorporates expectations about future cash flows and discount rates. Several studies have confirmed the predictive power of stock market returns for investment and output, among them Fama (1981), Fischer and Merton (1984), and Barro (1990). On the other hand, the finding of Campbell et al. about the predictive power of stock market volatility for future economic activity is new, but the authors do not provide a theoretical explanation for the evidence. In this article, I try to reconcile the results of Campbell et al. with earlier empirical evidence on the predictive power of stock market returns and finance theory.