Flight-to-quality, economic fundamentals, and stock returns ☆

We find that the order flow differential (OFD), a flight-to-quality measure constructed as the difference between large- and small-cap stock order flows, strongly and negatively forecasts output growth and interest rates in the U.S. The predictive ability of OFD for future macroeconomic fundamentals is robust to the inclusion of return factors and business cycle predictors, and it is thus a state variable candidate in the spirit of Merton (1973). Consistent with this view, we document that OFD commands a statistically significant negative risk premium in cross-sectional asset pricing tests.