oktober 24, 2016

The investor that predicts stock returns without even knowing it!

What are investors’ current stock return expectations? That is a question commonly found in the financial press. Typically, the type of investor one has in mind is the stock market investor. Not commodity investors, property investors or other investors. That makes sense since zinc investors or apartment block investors have other things to think about than whether the typical publically listed stock will go up or down in the future.

There is one other group of investors that actually care about the future valuation of public companies, however, and that is the credit market investor. Investors who buy corporate bonds (or credit default swaps) also care about the future wellbeing of the company. What’s more, these investors often take a long-term view of the company and its valuation.

In the paper Stock Return Expectations in the Credit Market (which you can find here) I suggest a way of extracting these investors’ expectations of future stock returns. To do this I compute long-term stock return expectations (across the business cycle) for individual stocks using information backed out from the credit derivatives market.

Empirically, the paper demonstrates a close relationship between these credit-implied stock return expectations and future realized stock returns. I also find stock portfolios selected based on credit-implied stock return forecasts to beat equally- and value-weighted portfolios of the same stocks out-of-sample. Basically, it seems that credit investors are good at predicting stock returns, without really even knowing it!