Inferring Aggregate Market Expectations from the Cross-Section of Stock Prices

Abstract

We introduce a new approach to predicting market returns using the cross-section of earnings and book values to explain current stock prices and extract aggregate expected returns. The proposed measure is countercyclical; it portends a significant fraction of the time-series variation in stock market returns at horizons of one month to one year, and outperforms numerous other measures, both in-sample and out-of-sample. We also find that it predicts returns in international equity markets. We use it to infer aggregate risk aversion, and find a downward trend in aggregate risk aversion and expected returns over time, leading to improvements in the information environment. We show that future aggregate earnings response coefficients increase over time, reflecting improved price informativeness.

Keywords: equity premium; future earnings response coefficients; valuation models

JEL Classification: G10, G14