ELSEVIER Journal of Financial Economics 40 (1996) 213-237 Elcumhaa Business conditions, monetary policy, and expected security returns Gerald R. Jensen**a, Jeffrey M. Mercer”, Robert R. Johnsonb “Department of Finance, Northern Illinois University, DeKalb, IL 60115. USA bDepartment of Economics and Finance, Creighton University. Omaha, NE 68178, USA (Received September 1994; final versionreceived July 1995) Abstract We examine the evidence that expected security returns can be forecasted by the term premium, default premium, and dividend yield, in light of recent findings that similar security return patterns are associated with Federal Reserve monetary policy develop- ments. We extend Fama and French’s (1989) analysis by suggesting that the monetary environment influences investors’ required returns, and hence the robustness of the models they propose. Our findings indicate that Fama and French’s results vary dramati- cally across monetary environments; that is, the behavior of the business-conditions proxies and their influence on expected security returns is significantly affected by the monetary sector. Key words: Business conditions; Monetary policy; Expected security returns JEL classification: E32; E44; G12 1. Introduction A growing body of research supports the view that variation in security returns across time is predictable. Keim and Stambaugh (1986), Campbell *Corresponding author. We acknowledge the helpful comments of William Dare, Eugene Fama (the referee), Scott Hein, Bill McDonald, Robert Miller, James Moser, Harold Mulherin, JamesSchmidt, G. William Schwert (the editor), participants at the 1994 Financial Management Association meeting in St. Louis, and participants in finance workshops at Texas Tech University and the University of Nebraska. Jensen and Mercer also acknowledge the financial support of the Northern Illinois University Graduate School Fund and the Office of the Dean, College of Business,Northern Illinois University. 0304-405X/96/$15.00 0 1996 Elsevier Science S.A. All rights reserved SSDI 0304405X95400845 6