Business Conditions and Expected Returns on Stocks and Bonds

The issues of whether the expected returns on bonds and stocks move together and whether the variation in expected bond and stock returns is related to business conditions are examined. Value- and equal-weighted portfolios of New York Stock Exchange stocks and a sample of monthly bond returns and yields for the period 1926-1987 are used. Expected returns on common stocks and long-term bonds contain a term or maturity premium that has a clear business-cycle pattern; it is low near peaks and high near troughs. Expected returns also have a risk premium that is related to longer term aspects of business conditions. The variation through time in this premium is stronger for low-grade bonds than for high-grade bonds and is stronger for stocks than for bonds. The general conclusion is that expected returns are lower when economic conditions are strong and higher when conditions are weak.