PREDICTABILITY OF STOCK RETURNS AND REAL OUTPUT

This paper investigates the predictability of stock returns using different components of output. Instead of using aggregate output as the state variable, we decompose aggregate output into its permanent and transitory components. Our empirical results indicate that the permanent component of output provides virtually all of the predictability attributed to the aggregate output variable. The transitory component of output is shown to contain no useful information regarding the predictability of stock returns. We argue that these results are consistent with general equilibrium pricing models and efficient markets.