Good Times or Bad Times? Investors' Uncertainty and Stock Returns
Publication Date
8-3-2004
Abstract
This paper investigates empirically the dynamics of investors' beliefs and Bayesian uncertainty on the state of the economy as state variables that describes the time-variation in investment opportunities. Using measures of uncertainty constructed from the state probabilities estimated from two-state regime-switching regime models of aggregate market return, and of aggregate output, I find a negative relationship between the level of uncertainty and asset valuations. This relationship shows substantial cross-sectional variation across portfolios sorted on size, book-to-market and past returns, especially conditional on the state of the economy. I show that a conditional model with investors' beliefs and uncertainty risk factor, is remarkably successful in explaining a large part of the cross-sectional variation in average portfolio returns. The uncertainty risk factor retains its incremental explanatory power when contrasted with other economically-motivated factors such as GDP news, or other conditional models such as (C)CAPM.
Document Type
Article
Keywords
uncertainty, beliefs, cross-section of returns, switching regime
Disciplines
Finance
DOI
10.2139/ssrn.558550
Source
SMU Cox: Finance (Topic)
Language
English
