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Stock market volatility and the Great Moderation

  • Sean D. Campbell
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    Using data on corporate profits forecasts from the Survey of Professional Forecasters, I decompose real stock returns into a fundamental news component and a return news component and analyze the effects of the Great Moderation on each. Empirically, the response of each component of real stock returns to the Great Moderation has been quite different. The volatility of fundamental news shocks has declined by 50% since the onset of the Great Moderation, suggesting a strong link between underlying fundamentals and the broader macroeconomy. Alternatively, the volatility of return news shocks has remained stable over the Great Moderation period. Since the bulk of stock market volatility is attributable to return shocks, the Great Moderation has not had a significant effect on stock return volatility. These empirical findings are shown to be consistent with Campbell and Cochrane's (1999) habit formation asset pricing model. In the face of a large decline in consumption volatility, the volatility of fundamental news shocks declines while the volatility of return shocks stagnate. Ultimately, the effect of a Great Moderation in consumption volatility on overall stock return volatility in the habit formation model is slight.

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    Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2005-47.

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    Date of creation: 2005
    Date of revision:
    Handle: RePEc:fip:fedgfe:2005-47
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    1. Allan Timmermann & Graham Elliott & Ivana Komunjer, 2004. "Biases in Macroeconomic Forecasts: Irrationality or Asymmetric Loss?," Econometric Society 2004 North American Summer Meetings 601, Econometric Society.
    2. Robert J. Shiller & John Y. Campbell, 1986. "The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors," Cowles Foundation Discussion Papers 812, Cowles Foundation for Research in Economics, Yale University.
    3. Campbell, John & Shiller, Robert, 1988. "Stock Prices, Earnings, and Expected Dividends," Scholarly Articles 3224293, Harvard University Department of Economics.
    4. Martin Lettau & Sydney Ludvigson & Jessica A. Wachter, 2005. "The declining equity premium: what role does macroeconomic risk play?," Proceedings, Board of Governors of the Federal Reserve System (U.S.).
    5. John Y. Campbell, 1990. "A Variance Decomposition for Stock Returns," NBER Working Papers 3246, National Bureau of Economic Research, Inc.
    6. Ben S. Bernanke & Kenneth N. Kuttner, 2005. "What Explains the Stock Market's Reaction to Federal Reserve Policy?," Journal of Finance, American Finance Association, vol. 60(3), pages 1221-1257, 06.
    7. Cochrane, John H. & Campbell, John, 1999. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Scholarly Articles 3119444, Harvard University Department of Economics.
    8. John Y. Campbell & Tuomo Vuolteenaho, 2003. "Bad Beta, Good Beta," NBER Working Papers 9509, National Bureau of Economic Research, Inc.
    9. Martin Lettau & Sydney Ludvigson, 2001. "Resurrecting the (C)CAPM: A Cross-Sectional Test When Risk Premia Are Time-Varying," Journal of Political Economy, University of Chicago Press, vol. 109(6), pages 1238-1287, December.
    10. James H. Stock & Mark W. Watson, 2003. "Has the Business Cycle Changed and Why?," NBER Chapters, in: NBER Macroeconomics Annual 2002, Volume 17, pages 159-230 National Bureau of Economic Research, Inc.
    11. Dean Croushore, 1993. "Introducing: the survey of professional forecasters," Business Review, Federal Reserve Bank of Philadelphia, issue Nov, pages 3-15.
    12. Schwert, G William, 1989. " Why Does Stock Market Volatility Change over Time?," Journal of Finance, American Finance Association, vol. 44(5), pages 1115-53, December.
    13. G. Constantinides, 1990. "Habit formation: a resolution of the equity premium puzzle," Levine's Working Paper Archive 1397, David K. Levine.
    14. John Y. Campbell & John Cochrane, 1999. "Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Journal of Political Economy, University of Chicago Press, vol. 107(2), pages 205-251, April.
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