Introduction

Chapter 1 contains an overview of the book. Part I introduces key concepts, definitions, and stylized facts regarding long–run economic growth and stock returns.Part II analyses the relation between economic growth and stock returns in the long run. Part III examines the shorter-horizon relation between economic growth and stock returns: the relation over the business cycle. Part IV explains how to make reasonable projections for economic activity, both for the short and the long run. Part V deals with expected future stock returns. The final part, a short one including one chapter only, explains how one can use the insights from the book when making investments.

Growth and returns across countries

This chapter examines the relation between long-run economic growth and returns across countries. Have countries that have experienced high GDP growth historically also experienced high stock returns? The chapter contains three main messages. First, there is no clear tendency that countries that have grown fast in the past are also countries that have delivered high stock returns in the past. Second, as in the US, stock prices have in many countries followed economic activity in the long run. Third, real interest rates relate to economic growth across countries in the long run.Another conclusion emerging from this chapter is that long-run stock returns exceed long-run rates of economic growth and long-run risk-free rates by a wide margin.

Building and maintaining investment portfolios

This last chapter in the book provides research-based perspectives on a number of challenges investors face when building and maintaining investment portfolios. The paper discusses portfolio diversification, the active vs. passive debate, the asset allocation decision, i.e. what determines the fraction of a portfolio that should be invested in stocks, practical advice on how the economic environment should affect your asset allocation, and other topics.

Judging the stance of the business cycle

This chapter describes if and how we can detect business-cycle turning points. What variables should we study if we want to say something about the likelihood that the business cycle will change? The chapter discusses business-cycle ‘indicators’. It distinguishes between lagging, coincident, and leading indicators. Lagging indicators refer to economic variables that react to a change in the business cycle, i.e. variables that react after a business-cycle turning point. Coincident indicators tell us something about where we are right now in the business cycle. Leading indicators, which are probably the most important ones, tell us about the near-term outlook for the business cycle, i.e. forecast the business cycle. The chapter emphasizes that business-cycle turning points are hard to predict, but also that some indicators are more informative than others.

The outlook for long-run economic growth

The chapter discusses theory and empirics regarding long-run economic growth. After reviewing the historical facts, the chapter discusses likely scenarios for long-run growth. The chapter also presents the arguments in a heated discussion where one side argues that growth will be tremendously high going forward, but the other argues future growth will be low. The chapter concludes that it does not seem likely that growth will be superhigh going forward. Will it be very low, then? In Advanced Economies, growth will probably be lower than the historical average, but in other parts of the world, growth will most likely be just fine.

Value, size, sector, and momentum stocks

This chapter studies the characteristics of the most important and well-known factors. Factor portfolios are portfolios of stocks based on certain characteristics, such as the size of the company, the price of the stock in relation to, e.g., the earnings of the company, the sector within which the firm operates, etc.Factors that perform better than the overall stock market tend to suffer more during recessions. To compensate investors for their underperformance during recessions, returns on these factors during expansions are so high that average stock returns over the full business cycle end out being high. Conversely, those factors that provide lower average returns than the overall stock market do so because they perform relatively better during recessions. The business cycle again plays an important role for understanding stock-market patterns.

Business-cycle fluctuations in economic activity

This chapter explains what the business cycle is and what causes business-cycle fluctuations. We call fluctuations in economic activity around the long-term growth trend ‘the business cycle’. The business cycle consists of two phases. The first is a period of strong economic activity. The second, following the first, is a period of weak economic activity. We call the first phase of the business cycle an ‘expansion’ and the second phase a ‘contraction’ or ‘recession’. The chapter explains what causes business cycles, and examines the empirical evidence on the lengths and strengths of the typical business cycle. It finds that expansions typically last longer than recessions. The chapter also shows that the length of expansions has increased during recent decades.

The 2008–2009 financial crisis and its aftermath

This chapter analyses the financial crisis of 2008-2009. The purpose is to further the understanding of the behavior of business cycles by moving from insights based on many years of data to a specific example of a business cycle: The 2008–2009 financial crisis and the years surrounding it. This specific example is, on top of it, a fascinating one. The chapter explains the situation prevailing before the crisis (the expansion), then moves on to the crisis itself (the contraction), and finally its aftermath.

The stock market over the business cycle

This chapter describes how the stock market relates to the business cycle. Stocks do badly during recessions and excellently during expansions. Earnings of firms drop during recessions. Stock prices drop as well, whereas dividends do not. This means that the stock-price dividend multiple contracts during recessions. If stock prices drop by more than dividends, it must be because investors have increased their expectations of future discount rates and/or lowered their expectations to future dividend/earnings growth. The chapter discusses the academic research on this issue. The chapter also shows that bonds do better than stocks during recessions. This has not least to do with the fact that central banks lower the monetary policy rate during recessions.Lower interest rates lead to higher bond prices, causing bonds to perform well during recessions.

Monetary policy, interest rates and stock markets

This chapter examines how monetary policy, in itself and through its dependence on the business cycle, affects prices on financial assets. The chapter shows that changes in the monetary policy rate affect yields on government bonds with longer maturity as well as corporate bonds. This typically dampens economic activity. Changes in monetary policy typically also have a negative impact on the stock market. The chapter discusses whether monetary policy in itself affects the stock market or whether it works via its effect on the business cycle. It turns out that economic activity in itself, and monetary policy in itself, both affect the stock market. It is important to be aware of both channels, i.e. how economic activity affects the stock market and how monetary policy affects the stock market.