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

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  • Alfonso Mendoza Velázquez
  • Peter N. Smith

Abstract

The equity premium 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. Official business cycle dating methods as well as identified structural macroeconomic shocks are examined. The findings are that there is clear evidence for counter-cyclicality 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 significant counter cyclical impact on returns. This paper analyses a long period of UK data for determining realised returns using revised data as well as expected returns using a shorter dataset of real-time data. The paper finds similar results for the two datasets suggesting that realsied and expected returns may not be so different from one another. The paper also assesses the ability of the models to forecast outside of their sample period.
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Suggested Citation

  • Alfonso Mendoza Velázquez & Peter N. Smith, 2013. "Equity Returns and the Business Cycle: the Role of Supply and Demand Shocks," Manchester School, University of Manchester, vol. 81, pages 100-124, September.
  • Handle: RePEc:bla:manchs:v:81:y:2013:i::p:100-124
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    File URL: http://hdl.handle.net/10.1111/manc.12022
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    References listed on IDEAS

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    1. repec:eee:pacfin:v:43:y:2017:i:c:p:200-217 is not listed on IDEAS

    More about this item

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy

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