Working Paper: NBER ID: w26435
Authors: Josh Davis; Alan M. Taylor
Abstract: Research finds strong links between credit booms and macroeconomic outcomes like financial crises and output growth. Are impacts also seen in financial asset prices? We document this robust and significant connection for the first time using a large sample of historical data for many countries. Credit boom periods tend to be followed by unusually low returns to equities, in absolute terms and relative to bonds. Return predictability due to this leverage factor is distinct from that of established factors like momentum and value and generates trading strategies with meaningful excess profits out-of-sample. These findings pose a challenge to conventional macro-finance theories.
Keywords: credit cycles; asset returns; leverage factor; investment performance
JEL Codes: E17; E20; E21; E32; E44; G01; G11; G12; G17; G21; N10
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Higher credit growth (d3credgdp) (E51) | lower future returns to equities (G12) |
| leverage factor (d3credgdp) (F62) | improved predictive power of asset return models (C58) |
| leverage factor (d3credgdp) (F62) | increased Jensen’s alpha and Sharpe ratios (G11) |
| credit booms (d3credgdp) (E51) | equity underperformance (G12) |