The Leverage Factor: Credit Cycles and Asset Returns
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Rapid credit growth predicts below-average equity returns, with high credit growth associated with 6.8% returns vs 11.6% when growth is low.
"... Using long-run annual panel data for the advanced economieswe show that credit booms are a negative predictor for real GDP growth looking forward, as has been noted (Mian, Sufi, and Verner 2017);but they are also a negative predictor for future returns to the major asset classes, equities and bonds. Higher credit growth predicts lower returns to equities in absolute terms, and for equities relative to bonds. In short, when a credit boom is maturing, the investor exposed to equities would face a more likely drawdown, while the investor exposed to bonds would not.....
Josh Davis and Alan M. Taylor, "The Leverage Factor: Credit Cycles and Asset Returns," National Bureau of Economic Research, November 2019, https://www.nber.org/papers/w26435bn
New Alan Taylor finds that rapid growth in credit (measured by the lagged three-year change in the ratio of total bank loans to GDP) is a predictor of less than average equity returns. Taylor finds that market leverage has historically predicted one year ahead stock returns better than measures of stock market momentum, and almost as well as measures of value. He find (Post World War Two, Table 1)the average return to stocks in sample of countries was 8.9 percent. When lagged growth in the credit-to-GDP ratio was < median the return averaged 11.6 percent. But when the credit growth ratio was high, returns the following year averaged only 6.8 percent.When testing his result he found that theSharpe ratio for the leverage factor alone was 0.78, better than the analogous measure of 0.70 for momentum but not quite as high as 0.82 for value. They found that a portfolio adjustment using all three variables, credit booms, momentum, and value generates a Sharpe ratio of 0.94.
Ed Comment:Interesting, although there haven’t been many business cycles (to regress against) since wwii. I would think it would depend on why credit is booming a) for investment (interest rates rising), in shich case growth and returns should be higher or b) because there is a surplus of savings, in which case rates would be lower, the market might already be higher because of lower rates, growth might be slower with less investment and so lagged stock price growth might less. I don’t know what they are measuring.