STOCK RETURNS AND THE BUSINESS CYCLEMichael DeStefano

OverviewDo 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

IntroductionThe 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 components?Fama and French (1988) & Poterba and

Summers (1988)Find mean reverting patterns in 3 to 5 year

returnsMovements in expected returns are often tied

to changes in business conditionsFama 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 ReturnsModeling 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 conditions

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 StagesNBER defines periods of recessions and

expansions by publishing peak and trough dates in economic activityExpansions: begin at trough date, end at peak dateRecessions: begin at peak date, end at trough date

4 stagesStage I: early expansionStage II: late expansion Stage III: early recession Stage IV: late recession

Sample PeriodNovember 1948 to March 2001Stages I and II have more observations

than Stages III and VIExpansions have historically been much

longer than recessions (5 years vs. 11 months)

Determinants of stock pricesDeterminants of stock prices:

Expected earningsThe discount rate (interest rates)

Stock prices vary directly with expected earnings and inversely with interest rates

Assumptions Assumptions:

1. Stock prices lead business cycles2. Earnings movements coincide with the

business cycle3. 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 FindingsSeparate regressions for each business-cycle

stage are used to analyze the effects of determinants within each stageThey 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 FindingsExpected returns are often believed to move

inversely with economic activity and current stock prices

Business cycles:Stage I: stock prices rise, expected returns fallStage 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

ConclusionsStage 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 ThoughtsFundamental 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 activity

During periods prior to turning points in the business cycle, large and persistent unexpected returns cause realized returns to be poor indicators of expected returns