Davids, Goliaths and Business Cycles

 A long literature in financial economics implies that the relative performance of firms with worse access to external financing should forecast aggregate market returns and future real economic activity. We test this implication with a new variable GVD (Goliath versus David), which is the annual change in the weight of the largest firms in the aggregate stock market. We find that GVD is the best single predictor of market returns out-of-sample among nine traditional predictors, predicting quarterly market returns with an out-of-sample R2 of 6.3% in the 1976-2011 evaluation period. Moreover, GVD is the only variable among traditional predictors that forecasts stock returns and investment growth both in-sample and out-of-sample. GVD also forecasts returns and investment growth of the Fama-French ten size-sorted portfolios, with assets we ex-ante expect to be more sensitive to changes in the access to external financing displaying greater sensitivity to GVD. GDV’s predictive ability is robust, and not due to information contained in traditional variables, such as SMB and net payout. Overall, our findings imply that shocks to access to external financing often precede macroeconomic fluctuations suggesting that financial markets play an important role in real economic activity.

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