Stock market charts transforming into landscapes.

Decoding Economic Growth: Can Asset Pricing Factors Predict the Future?

Samir D’Costa in Business & Economy August 2025 • 4 min read.

"Dive into the intriguing world of finance and economics to uncover whether common asset pricing factors like size and value can forecast economic booms and busts."

In the intricate dance of finance and economics, considerable attention is devoted to identifying factors that influence stock returns. Over the past few decades, a multitude of such factors has emerged, each claiming a unique ability to explain market movements. Among the most prominent and empirically robust are the Size, Value, and Momentum factors, extensively studied by Fama & French (1993) and Jagadeesh and Titman (1993).

Fama and French (FF) proposed that their 3-factor asset-pricing model accounts for risks not captured by the traditional capital asset pricing model. They posited that Size (SMB) and Value (HML) serve as proxies for underlying state variables within Merton's Intertemporal Capital Asset Pricing Model (ICAPM). While many agree that incorporating factors like Size and Value enhances the explanatory power of asset pricing models, the fundamental economic rationale behind this improvement remains a subject of debate.

This article delves into this discussion by assessing whether a risk-based explanation exists for commonly used asset pricing factors. Specifically, it investigates whether historical returns on these factors can predict future economic growth, thus potentially validating their role as proxies for underlying economic risks.

Do Stock Market Signals Really Foretell Economic Tides?

Stock market charts transforming into landscapes.

For asset-pricing factors to be genuinely considered proxies for risk, they should ideally correlate with the overall state of the economy. Groundbreaking work by Liew and Vassalou (2000) (LV) explored this relationship, seeking to link asset pricing factors with economic growth. Their findings suggested that HML and SMB factors contain information relevant to future economic growth, beyond what is already reflected in the market factor. This study provided a foundation for explaining Size and Value factors from a risk-based perspective.

LV’s work is widely referenced. Cochrane (2008) noted that LV demonstrated that Size and Book-to-Market factors serve as "business cycle" variables, while Hodrick and Zhang (2001) echoed this sentiment. However, recent developments and data suggest the need to revisit and expand upon LV’s original research.

Data Limitations: LV (2000) acknowledged that their results might lack robustness for certain markets due to limited stock data. Even in the U.S., extending the analysis with data from the FF data library weakened their initial findings.
Data-Snooping and Statistical Biases: Concerns highlighted by Lo and Mckinlay (1990) and McLean and Pontiff (2016) regarding data-snooping and statistical biases warrant a re-examination of LV's conclusions with more recent and higher-quality data.
Evolution of Multifactor Asset Pricing: Significant advancements have occurred in multifactor asset pricing since LV's study. New factors, such as those related to profitability and investment proposed by FF (2015), require evaluation to determine if they also align with a risk-based motivation.

Given the increased interest in emerging markets as attractive investment opportunities, it is also crucial to assess whether these factors behave consistently across both developed and emerging markets. This analysis will consider whether six key asset-pricing factors—Size, Value, Profitability, Momentum, Investment, and Quality—can predict future economic states, defined by changes in GDP and industrial production. The overarching aim is to determine if returns on these asset pricing factors act as leading indicators of economic activity.

The Verdict: Do Asset Pricing Factors Really Hold Predictive Power?

In conclusion, this out-of-sample analysis suggests that the six common factors studied do not provide strong evidence for predicting future GDP growth. While the market factor shows some predictive ability, other factors' signals appear to have attenuated over time. This calls into question the definitive risk-based explanation for these asset-pricing factors, suggesting the need for careful reassessment by researchers using ICAPM or similar risk-oriented models.

About this Article -

This article was crafted using a human-AI hybrid and collaborative approach. AI assisted our team with initial drafting, research insights, identifying key questions, and image generation. Our human editors guided topic selection, defined the angle, structured the content, ensured factual accuracy and relevance, refined the tone, and conducted thorough editing to deliver helpful, high-quality information.See our About page for more information.

This article is based on research published under:

DOI-LINK: 10.1016/j.econlet.2018.04.031, Alternate LINK

Title: Asset Pricing Factors And Future Economic Growth

Subject: Economics and Econometrics

Journal: Economics Letters

Publisher: Elsevier BV

Authors: Vaibhav Lalwani, Madhumita Chakraborty

Published: 2018-07-01

Everything You Need To Know

How do factors like Size and Value relate to Merton's Intertemporal Capital Asset Pricing Model (ICAPM)?

Fama and French proposed that Size, represented by SMB, and Value, represented by HML, serve as proxies for underlying state variables within Merton's Intertemporal Capital Asset Pricing Model, or ICAPM. This model suggests that these factors account for risks not captured by the traditional Capital Asset Pricing Model. The underlying economic rationale for this improvement is debated, with some believing they reflect economic risks.

What did Liew and Vassalou discover about the relationship between HML, SMB and future economic growth, and why is it important to revisit their work?

Liew and Vassalou's work suggested that HML (Value) and SMB (Size) factors contain information relevant to future economic growth, beyond what is already reflected in the market factor. Cochrane (2008) noted that LV demonstrated that Size and Book-to-Market factors serve as "business cycle" variables. However, data limitations, statistical biases, and the evolution of multifactor asset pricing call for a re-examination of these initial findings.

Which asset-pricing factors were analyzed to predict future economic states, and how was economic state defined?

The analysis assessed whether returns on six key asset-pricing factors—Size, Value, Profitability, Momentum, Investment, and Quality—can predict future economic states, defined by changes in GDP and industrial production. The aim was to determine if returns on these asset pricing factors act as leading indicators of economic activity across both developed and emerging markets.

Did the study confirm that asset pricing factors strongly predict GDP growth?

The out-of-sample analysis suggests that the six common factors studied, including Size, Value, Profitability, Momentum, Investment and Quality, do not provide strong evidence for predicting future GDP growth. While the market factor shows some predictive ability, other factors' signals appear to have attenuated over time. This calls into question the definitive risk-based explanation for these asset-pricing factors, suggesting the need for careful reassessment by researchers using ICAPM or similar risk-oriented models.

What limitations and challenges exist when using asset pricing factors like Size, Value, and Momentum to predict economic growth?

The analysis faced challenges from data limitations, potentially compromising the robustness of findings, particularly in emerging markets. Concerns about data-snooping and statistical biases, require a re-evaluation with higher-quality data. Also, significant advancements in multifactor asset pricing, such as the introduction of new factors like Profitability and Investment, necessitate evaluating whether these align with a risk-based motivation. Without addressing these, the predictive power and risk-based explanation of factors like Size, Value, and Momentum remain questionable.