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Research: Credit conditions and stock return predictability
2015-09-08 10:07:14
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The international academic publication, Journal of Monetary Economics, has published research co-authored by a Peking University HSBC Business School (PHBS) faculty member. Credit Conditions and Stock Return Predictability,” by Sudheer Chava , Michael Gallmeyer and PHBS assistant professor Heungju Park, analyzes the stock return predictability in the U.S. based on bank lending standards (Standards), proving that Standards can be a good predictor of stock returns.
 

Since the French mathematician Louis Bachelier discussed the use of Brownian motion to evaluate stock options in his thesis in 1900, stock return predictability has been a heated issue in the finance sector. A growing body of research in recent years has used survey data to explain stock returns and macroeconomic variables. Some have used variables such as market valuation ratios, short-and long-term interest rates, firm financing patterns, and consumption-to-wealth ratio to analyze stock predictability. Other researchers seek to find direct links between stock return predictability and aggregate macroeconomic supply variables.
 
Credit Conditions and Stock Return Predictability examines whether bank lending standards (Standards), a variable that captures aggregate supply-side credit conditions, serves as a leading indicator of future stock returns. Generally, Standards refer to the terms under which loans are offered. Banks will decide whether a loan applicant (corporate/ individual) meets Standards by evaluating its financial conditions, cash flows, liability and profitability. Based on changes in lending standards, the market could know whether commercial banks are easing or tightening credit. So, bank lending standards have been used as a bank loan supply measure to study whether banks change their loan supply systematically over the business cycle and if there is an important loan supply effect in macroeconomic fluctuations.
 
To provide direct evidence of the relationship between credit conditions through a bank loan supply measure and future excess stock returns, this research uses survey data on bank lending standards obtained from the Federal Reserve’s Senior Loan Officer Opinion Survey (SLOS). Questions in the survey typically deal with changes in bank leading conditions: Over the past three months, how have your bank's credit standards for approving applications for C&I loans or credit lines to small firms changed? According to the statistics, credit standards would tend to be “tightened considerably” before each economic downturn in the U.S. Thus, this credit condition measure (Standards) is able to predict macroeconomic variables. And it performs well both in-sample and out-of-sample, as the research suggests.
 
Further, researchers employ empirical methods to study predictability by analyzing stock returns on the CRSP value-weighted index (CRSP-VW) and the S&P 500 index. The CRSP is a comprehensive database for historical security prices and returns information. The S&P 500 is an American stock market index based on the market capitalizations of 500 large listed companies. Moreover, the robustness of Standards as a stock return predictor is also proved by small sample bias analysis and other consistency checks.
 
The research findings show that Standards, a measure of aggregate supply-based credit conditions, is a strong predictor of U.S. stock returns at frequencies up to and including a year, especially in the post-1990 data period. Specifically, bank lending standards could predict stock returns through cash flow channels because it poses direct and intense impact on cash flows. Tightening credit standards predict lower expected future cash flows, therefore lower future stock returns. Given that Standards has been shown to predict aggregate macroeconomic variables, the results have proved a direct link between a macroeconomic supply variable and the predictability of asset returns. Additionally, the research evidence also suggests that Standards’ predictability is primarily driven by a cash flow news channel, consistent with the view that banks’ inability or unwillingness to lend funds can cause firms to forego some positive net present value (NPV) projects, leading to decrease in firm value.
 
Though previous research has proved that bank lending is linked to macroeconomic variables, the direct linkage between loan supply and stock returns is not yet well examined. Park commented that “despite this linkage of bank lending to macroeconomic variables, limited evidence exists whether changes in bank loan supply predict stock returns, which is our contribution.” It is beneficial for practitioners to predict stock returns and adjust investment portfolios accordingly.

By Jin
Edited by  P. Young