Expected returns and the business cycle: heterogeneous agents and heterogeneous goods

Finance

IFA Working Paper

2006

I document that the expected excess stock market returns contain both low-frequency and higher-frequency components. The low-frequency variation is associated with price-related variables such as the divided/price ratio, while the higher-frequency variation is associated with business cycle variables such as GDP growth. The two components interact. In particular, when the low-frequency component of the equity premium is high, the impact of the business cycle fluctuations on the equity premium is stronger. I propose a simple explanation: fundamental risks in the economy fluctuate at a business cycle frequency, while the risk tolerance of the marginal investor varies at a lower, "generational" frequency. I construct a general equilibrium model with heterogeneous agents and heterogeneous goods that can account for the new empirical findings. The equilibrium interaction of the dynamic allocation of wealth across agents and of consumption across goods give rise to the empirical relation between the low-frequency price variables, the higher-frequency business-cycle variables, and future excess stock market returns.

This working paper is now forthcoming in the Review of Financial Studies

Institute of Finance and Accounting

FIN 453

IFA Working Paper

No