Business cycles and asset returns.

Abstract

This research explores the relation between business cycles and financial asset returns. In particular, the effect of business cycles on stock returns and in the insurance rates of returns are explored. With respect to stock returns, a more general framework of analysis is described which relates stock returns, output and inflation to a set of exogenously given factors. Output and inflation are modeled as being jointly determined by a set of exogenous factors. These factors are found to affect stock returns in the same direction that they influence output. The major hypothesis test whether inflation has any effect on stock returns once exogenous factors have been controlled for. Tests were performed on annual data for both pre and post World War II years. Results of prewar tests were generally inconclusive, while results of the postwar tests strongly support this hypothesis. Cycles in property-casualty underwriting profits are different than the cycles in either gross national product or corporate profits as a whole. To examine the returns to insurance firms from underwriting, a simple pricing model for insurance is presented. The major implication is that in a rational expectations world where insurance firms use more than just the information available from past losses to set premiums, premiums should cause or predict losses. Causality test were used to explore this implication. Test results indicate that premiums do not cause or predict losses, but rather, that losses cause or predict premiums. Further tests were then performed to examine whether the market imperfection is an institutional aspect of the insurance industry, or rather the imperfection is a capital market imperfection, as one author argued. Test results indicate that the imperfection is not a capital market imperfection.