Title

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

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