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

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  • Alfonso Mendoza-Velazquez
  • Peter N. Smith

Abstract

The price of aggregate risk in the UK appears to have risen significantly since the start of the financial crisis and the associated extended recession. This paper examines the relationship between the business cycle and equity market returns to see how robust this association is. Several classifications of UK business cycle quarters are examined and related to the returns from an investment strategy which buys the market one or more quarters after a business cycle quarter and holds it for one year. O¢cial business cycle dating methods as well as identified structural macroeconomic shocks are examined. The findings are that there is clear evidence for countercyclicality in excess returns. Returns are significantly higher in the year following a recession rather than an expansion quarter. There is also a significant difference in the pattern of returns if the downturn in the quarter is the result of a supply or demand shock. Negative supply shocks are found to have an especially large and signicant counter cyclical impact on returns.

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Bibliographic Info

Paper provided by Department of Economics, University of York in its series Discussion Papers with number 12/36.

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Date of creation: Dec 2012
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Handle: RePEc:yor:yorken:12/36

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Keywords: Equity Returns; Risk Premium; Business Cycle;

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  1. Lustig, Hanno & Verdelhan, Adrien, 2012. "Business cycle variation in the risk-return trade-off," Journal of Monetary Economics, Elsevier, vol. 59(S), pages S35-S49.
  2. Don Harding & Adrian Pagan, 2000. "Disecting the Cycle: A Methodological Investigation," Econometric Society World Congress 2000 Contributed Papers 1164, Econometric Society.
  3. Andrew Ang & Sen Dong & Monika Piazzesi, 2007. "No-Arbitrage Taylor Rules," NBER Working Papers 13448, National Bureau of Economic Research, Inc.
  4. Anthony Garratt & Shaun P Vahey, 2005. "UK Real-Time Macro Data Characteristics," Birkbeck Working Papers in Economics and Finance 0502, Birkbeck, Department of Economics, Mathematics & Statistics.
  5. Clark, Todd E. & McCracken, Michael W., 2009. "Tests of Equal Predictive Ability With Real-Time Data," Journal of Business & Economic Statistics, American Statistical Association, vol. 27(4), pages 441-454.
  6. Jesús Fernández-Villaverde & Juan Francisco Rubio-Ramírez & Thomas Sargent, 2005. "A, B, C’s, (and D’s) for understanding VARs," Working Paper 2005-09, Federal Reserve Bank of Atlanta.
  7. Gerhard Bry & Charlotte Boschan, 1971. "Cyclical Analysis of Time Series: Selected Procedures and Computer Programs," NBER Books, National Bureau of Economic Research, Inc, number bry_71-1.
  8. Smith, Peter N & Sorensen, Steffen & Wickens, Michael R., 2009. "The Equity Premium and the Business Cycle: the Role of Demand and Supply Shocks," CEPR Discussion Papers 7227, C.E.P.R. Discussion Papers.
  9. Gerhard Bry & Charlotte Boschan, 1971. "Foreword to "Cyclical Analysis of Time Series: Selected Procedures and Computer Programs"," NBER Chapters, in: Cyclical Analysis of Time Series: Selected Procedures and Computer Programs, pages -1 National Bureau of Economic Research, Inc.
  10. Rangvid, Jesper, 2006. "Output and expected returns," Journal of Financial Economics, Elsevier, vol. 81(3), pages 595-624, September.
  11. Ilan Cooper, 2009. "Time-Varying Risk Premiums and the Output Gap," Review of Financial Studies, Society for Financial Studies, vol. 22(7), pages 2601-2633, July.
  12. Harding, Don & Pagan, Adrian, 2006. "Synchronization of cycles," Journal of Econometrics, Elsevier, vol. 132(1), pages 59-79, May.
  13. Kaminska, Iryna, 2008. "A no-arbitrage structural vector autoregressive model of the UK yield curve," Bank of England working papers 357, Bank of England.
  14. Keating, John W & Nye, John V, 1998. "Permanent and Transitory Shocks in Real Output: Estimates from Nineteenth-Century and Postwar Economies," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 30(2), pages 231-51, May.
  15. Sims, Christopher A, 1980. "Macroeconomics and Reality," Econometrica, Econometric Society, vol. 48(1), pages 1-48, January.
  16. Rodriguez, Rosa & Restoy, Fernando & Pena, J. Ignacio, 2002. "Can output explain the predictability and volatility of stock returns?," Journal of International Money and Finance, Elsevier, vol. 21(2), pages 163-182, April.
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