Stock-Market Crashes and Depressions
Long-term data for 30 countries up to 2006 reveal 232 stock-market crashes (multi-year real returns of -25% or less) and 100 depressions (multi-year macroeconomic declines of 10% or more), with 71 of the cases matched by timing. The United States has two of the matched events--the Great Depression 1929-33 and the post-WWI years 1917-21, likely driven by the Great Influenza Epidemic. 41% of the matched cases are associated with war, and the two world wars are prominent. Conditional on a stock-market crash (return of -25% or less) in a non-war environment, the probability of a minor depression (macroeconomic decline of at least 10%) is 22% and of a major depression (at least 25%) is 3%. For contexts of currency or banking crises that occur during times of global distress, these probabilities rise to 46% and 8%, respectively. These depression odds applied to the stock-market crashes of 2008 in the United States and many other countries. In reverse and again in a non-war environment, the probability of a stock-market crash (return of -25% or worse) is 67%, conditional on a depression of 10% or more, and 83% for 25% or more. Thus, the largest depressions are particularly likely to be accompanied by stock-market crashes. We allow for flexible timing between stock-market crashes and depressions for the 71 matched cases to compute the covariance between stock returns and an asset-pricing factor, which depends on the proportionate decline of consumption during a depression. If we assume a coefficient of relative risk aversion around 3.5, this covariance is large enough to account in a familiar looking asset-pricing formula for the observed average (levered) equity premium of 7% per year. This finding complements previous analyses that were based on the probability and size distribution of macroeconomic disasters but did not consider explicitly the covariance between macroeconomic declines and stock returns.
|Date of creation:||Feb 2009|
|Date of revision:|
|Note:||AP EFG IFM|
|Contact details of provider:|| Postal: |
Web page: http://www.nber.org
More information through EDIRC
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Xavier Gabaix, 2008.
"Variable Rare Disasters: An Exactly Solved Framework for Ten Puzzles in Macro-Finance,"
NBER Working Papers
13724, National Bureau of Economic Research, Inc.
- Xavier Gabaix, 2012. "Variable Rare Disasters: An Exactly Solved Framework for Ten Puzzles in Macro-Finance," The Quarterly Journal of Economics, Oxford University Press, vol. 127(2), pages 645-700.
- Robert J. Barro, 2009.
"Rare Disasters, Asset Prices, and Welfare Costs,"
American Economic Review,
American Economic Association, vol. 99(1), pages 243-64, March.
- Ravi Bansal & Amir Yaron, 2000.
"Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles,"
NBER Working Papers
8059, National Bureau of Economic Research, Inc.
- Ravi Bansal & Amir Yaron, 2004. "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles," Journal of Finance, American Finance Association, vol. 59(4), pages 1481-1509, 08.
- R. Mehra & E. Prescott, 2010.
"The equity premium: a puzzle,"
Levine's Working Paper Archive
1401, David K. Levine.
- Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, vol. 57(4), pages 937-69, July.
- Rietz, Thomas A., 1988. "The equity risk premium a solution," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 117-131, July.
- Leonard Nakamura & Carlos E.J.M. Zarazaga, 2001.
"Banking and finance in Argentina in the period 1900-35,"
01-7, Federal Reserve Bank of Philadelphia.
- Leonard Nakamura & Carlos E.J.M. Zarazaga, 2001. "Banking and finance in Argentina in the period 1900-35," Center for Latin America Working Papers 0501, Federal Reserve Bank of Dallas.
- Weil, Philippe, 1990. "Nonexpected Utility in Macroeconomics," The Quarterly Journal of Economics, MIT Press, vol. 105(1), pages 29-42, February.
- Carmen M. Reinhart & Kenneth S. Rogoff, 2009. "This Time Is Different: Eight Centuries of Financial Folly," Economics Books, Princeton University Press, edition 1, volume 1, number 8973.
- Barro, Robert, 2006. "Rare Disasters and Asset Markets in the Twentieth Century," Scholarly Articles 3208215, Harvard University Department of Economics.
- Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
When requesting a correction, please mention this item's handle: RePEc:nbr:nberwo:14760. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: ()
If references are entirely missing, you can add them using this form.