Stock Returns and the Business Cycle by xiaoyounan


Michael DeStefano
 Do movements in economic factors explain broad
  movements in stock returns over the business cycle?
 Findings:
   Stock returns decrease throughout expansions
   Returns become negative during 1st half of recessions
   Returns are largest during the 2nd half of recessions

 Findings confirm that expected returns vary inversely
  with economic conditions
 Yet suggest that realized returns are poor indicators of
  expected returns prior to turning points in the
  business cycle
 The major goal of the paper:
  To examine whether U.S. monthly index returns and economic factors
  have varied as predicted by the theoretical framework set forth by
  Bolten and Weigand (1998)

 Motivation behind the paper:
  Recent evidence of mean reverting patterns in stock prices and
  asymmetrical responses of stock prices to determinants

 The results of the paper provide insight into the relation
  between realized and expected returns over the business cycle
Do stock prices contain predictable
 Fama and French (1988) & Poterba and Summers
   Find mean reverting patterns in 3 to 5 year returns
 Movements in expected returns are often tied to
 changes in business conditions
   Fama and French (1989): expected returns contain risk
    premiums that move inversely with business conditions
   Whitelaw (1994): expected returns move inversely with the
    business cycle and conditional volatility leads the expected
    return cycle
   Equilibrium asset pricing model framework: consumption
    smoothing drives the relationship between the business
    cycle and expected returns
Asymmetries in Returns
 Modeling expected returns as a constant linear function of
  risk or deterministic variables may not be optimal
 Example:
    Perez-Quiros and Timmerman (1998)
       Find asymmetries in the conditional mean and volatility of excess stock
        returns around business cycle turning points
 Bottom line:
    Recurring patterns in stock prices are the result of changing
     expected returns, which are somehow related to business
    There is evidence that the means and higher moments of stock
     returns are subject to systematic shifts which have been tied to
     current economic conditions in some cases
    Stock returns can respond differently to economic factors
     depending on the state of the economy
Business Cycle Stages
 NBER defines periods of recessions and
 expansions by publishing peak and trough dates in
 economic activity
   Expansions: begin at trough date, end at peak date
   Recessions: begin at peak date, end at trough date
 4 stages
   Stage I: early expansion
   Stage II: late expansion
   Stage III: early recession
   Stage IV: late recession
Sample Period
 November 1948 to March 2001
 Stages I and II have more observations than Stages
 III and VI
   Expansions have historically been much longer than
    recessions (5 years vs. 11 months)
Determinants of stock prices
 Determinants of stock prices:
   Expected earnings
   The discount rate (interest rates)
 Stock prices vary directly with expected earnings
 and inversely with interest rates
 Assumptions:
  1. Stock prices lead business cycles
  2. Earnings movements coincide with the business cycle
  3. Investors form expectations about future earnings
     based on the cyclical movements in earnings
  4. Interest rate movements are procyclical but slightly
     lag the business cycle
  5. Investors expect the current stage to persist, but also
     anticipate the next stage
Methodology and Findings
 Separate regressions for each business-cycle stage
 are used to analyze the effects of determinants
 within each stage
   They indicate that movements in stock price
    fundamentals play a role in explaining this variation
    and that the effects of fundamentals on stock returns
    also vary across the business cycle
   The observation that R2 statistics decrease prior to
    business-cycle turning points suggests that stock
    returns are less driven by time-varying expected
    returns during these periods
Continued Findings
 Expected returns are often believed to move inversely
  with economic activity and current stock prices
 Business cycles:
   Stage I: stock prices rise, expected returns fall
   Stage II: stock prices continue to rise and expected returns
    continue to fall. However, at some point during Stage II
    stock prices reach a maximum and begin to decrease. Here,
    expected returns begin to increase because economic
    activity does not reach a maximum until the end of stage
    II, for a time it and expected returns vary directly
 Stage I
    Returns are positive
 Stage II
    Returns decrease close to zero due to falling expectations about
     future earnings and rising long-term interest rates
 Stage III
    Returns become highly negative
    The change in T-bill rates becomes a significant factor whereas
     changes in long-term rates turn highly insignificant
 Stage IV
    Positive returns
    High positive returns are attributed to expected earnings
Final Thoughts
 Fundamental determinants are able to explain a much
  larger amount of variation in stock returns during
  recessions than during expansions
 The amount of explained variation decreased in the
  latter half of both recessions and expansions
 The study is consistent with the popular notion that
  expected returns move inversely with economic
 During periods prior to turning points in the business
  cycle, large and persistent unexpected returns cause
  realized returns to be poor indicators of expected

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