Equity Return Dispersion and Stock Market Volatility: Evidence from Multivariate Linear and Nonlinear Causality Tests

This paper contributes to the literature on stock market predictability by exploring the causal relationships between equity return dispersion, stock market volatility and excess returns via multivariate nonlinear causality tests. Both bivariate and multivariate nonlinear causality tests yield significant evidence of causality from return dispersion to both stock market volatility and equity premium, even after controlling for the state of the economy. While we find significant causality from business conditions to return dispersion, we see that expansionary (contractionary) market states are associated with low (high) level of equity return dispersion, indicating asymmetries in the relationship between equity return dispersion and economic conditions. Overall, our findings suggest that both return dispersion and business conditions are valid joint forecasters of both the stock market volatility and excess market returns and that return dispersion possesses incremental information regarding future stock return dynamics beyond which can be explained by the state of the economy.