1. STOCK RETURNS AND THE BUSINESS CYCLE Michael DeStefano

2. Overview Do movements in economic factors explain broad movements in stock returns over the business cycle? Findings: Stock returns decrease throughout expansions Returns become negative during 1 st half of recessions Returns are largest during the 2 nd half of recessions Findings confirm that expected returns vary inversely with economic conditions Yet suggest that realized returns are poor indicators of expected returns prior to turning points in the business cycle

3. Introduction The major goal of the paper: To examine whether U.S. monthly index returns and economic factors have varied as predicted by the theoretical framework set forth by Bolten and Weigand (1998) Motivation behind the paper: Recent evidence of mean reverting patterns in stock prices and asymmetrical responses of stock prices to determinants The results of the paper provide insight into the relation between realized and expected returns over the business cycle

4. Do stock prices contain predictable components? Fama and French (1988) & Poterba and Summers (1988) Find mean reverting patterns in 3 to 5 year returns Movements in expected returns are often tied to changes in business conditions Fama and French (1989): expected returns contain risk premiums that move inversely with business conditions Whitelaw (1994): expected returns move inversely with the business cycle and conditional volatility leads the expected return cycle Equilibrium asset pricing model framework: consumption smoothing drives the relationship between the business cycle and expected returns

5. Asymmetries in Returns Modeling expected returns as a constant linear function of risk or deterministic variables may not be optimal Example: Perez-Quiros and Timmerman (1998)  Find asymmetries in the conditional mean and volatility of excess stock returns around business cycle turning points Bottom line: Recurring patterns in stock prices are the result of changing expected returns, which are somehow related to business conditions There is evidence that the means and higher moments of stock returns are subject to systematic shifts which have been tied to current economic conditions in some cases Stock returns can respond differently to economic factors depending on the state of the economy

6. Business Cycle Stages NBER defines periods of recessions and expansions by publishing peak and trough dates in economic activity Expansions: begin at trough date, end at peak date Recessions: begin at peak date, end at trough date 4 stages Stage I: early expansion Stage II: late expansion Stage III: early recession Stage IV: late recession

7. Sample Period November 1948 to March 2001 Stages I and II have more observations than Stages III and VI Expansions have historically been much longer than recessions (5 years vs. 11 months)

8. Determinants of stock prices Determinants of stock prices: Expected earnings The discount rate (interest rates) Stock prices vary directly with expected earnings and inversely with interest rates

9. Assumptions Assumptions: 1. Stock prices lead business cycles 2. Earnings movements coincide with the business cycle 3. Investors form expectations about future earnings based on the cyclical movements in earnings 4. Interest rate movements are procyclical but slightly lag the business cycle 5. Investors expect the current stage to persist, but also anticipate the next stage

10. Methodology and Findings Separate regressions for each business-cycle stage are used to analyze the effects of determinants within each stage They indicate that movements in stock price fundamentals play a role in explaining this variation and that the effects of fundamentals on stock returns also vary across the business cycle The observation that R 2 statistics decrease prior to business-cycle turning points suggests that stock returns are less driven by time-varying expected returns during these periods

11. Continued Findings Expected returns are often believed to move inversely with economic activity and current stock prices Business cycles: Stage I: stock prices rise, expected returns fall Stage II: stock prices continue to rise and expected returns continue to fall. However, at some point during Stage II stock prices reach a maximum and begin to decrease. Here, expected returns begin to increase because economic activity does not reach a maximum until the end of stage II, for a time it and expected returns vary directly

12. Conclusions Stage I Returns are positive Stage II Returns decrease close to zero due to falling expectations about future earnings and rising long-term interest rates Stage III Returns become highly negative The change in T-bill rates becomes a significant factor whereas changes in long-term rates turn highly insignificant Stage IV Positive returns High positive returns are attributed to expected earnings

13. Final Thoughts Fundamental determinants are able to explain a much larger amount of variation in stock returns during recessions than during expansions The amount of explained variation decreased in the latter half of both recessions and expansions The study is consistent with the popular notion that expected returns move inversely with economic activity During periods prior to turning points in the business cycle, large and persistent unexpected returns cause realized returns to be poor indicators of expected returns