Received: 16 June 2016 Revised: 26 December 2017 Accepted: 27 December 2017
What does the tail of the distribution of current stock prices
tell us about future economic activity?
José Vicente Gustavo Araujo
Departamento de Estudos e Pesquisas
(DEPEP), Banco Central do Brasil, Rio de
José Vicente, Departamento de Estudos e
Pesquisas (DEPEP), Banco Central do
Brasil, Rio de Janeiro, Brazil.
This paper proposes three leading indicators of economic conditions esti-
mated using current stock returns. The assumption underlying our approach
is that current asset prices reflect all the available information about future
states of economy. Each of the proposed indicators is related to the tail of the
cross-sectional distribution of stock returns. The results show that the leading
indicators have strong correlation with future economic conditions and usually
make better out-of-sample predictions than two traditional competitors (random
walk and the average of previous observations). Furthermore, quantile regres-
sions reveal that the leading indicators have strong connections with low future
crisis, economic activity, leading economic indicator, tail risk
Although business cycles are part of economic dynamics,
the effects of these fluctuations can be damaging. There-
fore, predicting cycles is an important task for policymak-
ers to enable actions to attenuate these effects. While the
term “cycle” might suggest periodicity, economic contrac-
tions or expansions do not follow a clear pattern, which
makes it hard to anticipate them. In light of this, lead-
ing economic activity indicators (LEI) are a relevant topic
of investigation. A LEI is simply an index or factor that
changes before economic activity starts following a new
trend or path. Most of the work about LEIs relies on time
series models estimated from monetary aggregates and/or
asset prices. In this paper, we propose three LEIs that are
based on stock prices at a given point in time. In particu-
lar, our indicators are different attributes of the tail of the
cross-sectional distribution of stock returns.
Economic theory states that the price of an asset reflects
its expected present value of future earnings adjusted by
risk. This statement, together with the market efficiency
hypothesis, tells us that any information about the future
states of nature should be reflected in prices. Therefore, it
is reasonable to imagine that current prices provide rele-
vant information to build LEIs. Moreover, as pointed out
by Bloom (2009), an increase in uncertainty leads firms
to postpone investment decisions, production, and hiring.
Since tail risk measures are related to uncertainty, one
can expect that they are correlated with macroeconomic
activity. As our main aim is to study falls in economic activ-
ity, we define an LEI as a measure of the left tail of the
distribution of current stock returns.
Cross-sectional data have been used to infer future eco-
nomic activity plunges. For instance, Allen, Bali, and Tang
(2012) derive a catastrophic risk measure from an extreme
lower percentile of stock returns at each point in time.
They show that this measure forecasts macroeconomic
downturns six months ahead. Moreover, another strand
of the literature connects tail events to asset pricing. This
literature tries to provide explanations for some financial
Kelly and Jiang (2014) propose an economy-wide
See Tsai and Wachter (2015) for a survey of recent models of disaster risk
that provide explanations for some puzzles in finance.
506 Copyright © 2018 John Wiley & Sons, Ltd. wileyonlinelibrary.com/journal/for Journal of Forecasting. 2018;37:506–516.