Debt-by-Price Ratio, End-of-Year Economic Growth, and Long-Term Prediction of Stock Returns

Abstract

With the prominent role of government debt in economic growth in recent decades, one would expect that government debt alongside economic growth to be a risk factor priced in the time series of stock returns. In this paper, this idea is investigated by applying a nonparametric model, namely, a local-linear kernel smoother with the aim of forecasting long-term stock returns where the model and smoothing parameters are chosen by cross-validation. While a wide range of predictive variables are examined, we find that our newly introduced debt-by-price ratio and the third to fourth quarter economic growth are robust predictors of stock returns, beating the well-known predictive variables in the literature by a significant difference. The combination of these two covariates can explain almost 30% variation of stock returns at a one-year horizon. This is very crucial considering the difficulty in capturing even a small proportion of movements in stock returns.