The equity premium and the business cycle: the role of demand and supply shocks

Abstract

This paper explores the effects of the US business cycle on US stock market returns through an analysis of the equity risk premium. We propose a new methodology based on the SDF approach to asset pricing that allows us to uncover the different effects of aggregate demand and supply shocks. We find that negative shocks are more important that positive shocks, and that supply shocks have a much greater impact than demand shocks. Copyright © 2009 John Wiley & Sons, Ltd.

Equity Returns and the Business Cycle: The Role of Supply and Demand Shocks

“…The estimates are shown in Table 9. The impact of negative supply shocks on returns isgenerally larger and more signi…cant than for other shocks at both horizons, in both datasets .This result complements those in Smith, Sorensen and Wickens (2010) for the impact of structural supply and demand shocks on the risk premium in US equity returns, where the risk premium is that of a stochastic discount factor (SDF) model with conditional moments modelled as GARCH processes. These models all have a superior out of sample forecasting perfromance than the aurtoregressive model according to the MSE-F statistics.…”

Can stochastic discount factor models explain the cross‐section of equity returns?

“…A likelihood ratio test is used to examine the hypothesis implied by each restricted model against the unrestricted model, M4. For M1, the conditional covariance of returns with consumption is highly significant, but the size of the coefficient, 83.25, implies an implausibly large CRRA, which is a common feature of consumption‐based models (Campbell, 2002; Cochrane, 2008; Yogo (2006); Smith et al, 2008, 2010) except for C‐CAPM with garbage growth of Savov (2011).…”

“…We follow the same econometric approach here as in Smith and Wickens (2002), Smith et al (2008), Smith, Sorensen, and Wickens (2010), and Abhakorn et al (2013) by using the multivariate generalized autoregressive conditional heteroskedasticity in mean model (MGM) to estimate the joint distribution of the excess return on equity with macroeconomic factors in such a way that the return satisfies the no‐arbitrage condition under the SDF framework. This approach is achieved by including conditional covariances of the excess equity returns and the macroeconomic factors in the mean of the asset pricing equations and constraining the coefficients on these time‐varying, conditional covariances according to the no‐arbitrage condition implied by each asset‐pricing model.…”

Housing price–volume correlations and boom–bust cycles

“…Acemoglu and Scott (1994) strongly support that the nonlinearity of the UK labor market is constructed successfully by a cyclical asymmetric model. Smith et al (2010) examine the relationship between US stock returns and business cycles and propose that downturns in business cycles cause a greater negative influence on stock returns than a positive effect in upturns-that is, the relation varies over a business cycle. Due to this asymmetry, corresponding strategies over a cycle should be made based on different market states (Dissanaike 1997).…”