The Unassuming Economist

From a paper by Nicolas Chatelais, Arthur Stalla-Bourdillon, and Menzie D. Chinn:

“After the Covid-shock in March 2020, stock prices declined abruptly, reflecting both the
deterioration of investors’ expectations of economic activity as well as the surge in aggregate risk
aversion. In the following months however, whereas economic activity remained sluggish, equity
markets sharply bounced back. This disconnect between equity values and macro-variables can
be partially explained by other factors, namely the decline in risk-free interest rates, and, for the
US, the strong profitability of the IT sector. As a result, an econometrician trying to forecast
economic activity with aggregate stock market variables during the Covid-crisis is likely to get
poor results. The main idea of the paper is thus to rely on sectorally disaggregated equity
variables within a factor model to predict future US economic activity. We find, first, that the
factor model better predicts future economic activity compared to aggregate equity variables or to
usual benchmarks used in macroeconomic forecasting (both in-sample and out-of-sample).
Second, we show that the strong performance of the factor model comes from the fact that the
model filters out the “expected returns” component of the sectoral equity variables as well as the
foreign component of aggregate future cash flows, and that it also over-weights upstream and
“value” sectors that are found to be closely linked to the future state of the US business cycle.”