We examine the roles played by bank lending cycle in predicting U.S. stock returns. Using a cycle component of U.S. commercial and industrial (C&I) loans (Lending Gap), we find that the cycle component is a strong predictor of U.S. stock returns. Lending Gap performs well both in-sample and out-of-sample and is robust to a small sample analysis. Moreover, we find that the aggregate stock returns respond more strongly to the cycle components during credit tightening periods and the stock returns of firms that primarily relied on banks for capital is more sensitive to the cycle components. The predictability of Lending Gap is consistent with capturing neglected risk with bank loan expansion.

Keywords: Return predictability, financial markets, bank loans
JEL Classification: E44, G12, G14, G17, G21​