Equity Returns, Unemployment, and Monetary Policy

We investigate both theoretically and empirically how unemployment level and its growth affect future stock returns. We find that both a higher unemployment rate and higher growth of unemployment positively predict future stock market returns. In our model, the effects come through their negative effect on equity market participation. Importantly, the two effects reinforce each other making stock returns exceptionally high in periods of high unemployment and high unemployment growth. Our findings are robust to alternative specifications, including using lagged unemployment data or unemployment forecasts. We document and examine theoretically why the same measures related to unemployment predict also the FED’s monetary policy. Controlling for FED’s future policies does not take away the return predictability