RFS Advance Access originally published online on December 11, 2008
Review of Financial Studies 2009 22(11):4377-4422; doi:10.1093/rfs/hhn097
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Good Times or Bad Times? Investors' Uncertainty and Stock Returns
University of North Carolina at Chapel Hill
Send correspondence to Arzu Ozoguz, Kenan-Flagler Business School, University of North Carolina at Chapel Hill, CB3490 McColl Building, Chapel Hill, NC 27599-3490. E-mail: arzu_ozoguz{at}unc.edu.
JEL Classification: G12, G14, D80
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Abstract |
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This paper investigates empirically the dynamics of investors' beliefs and Bayesian uncertainty about the state of the economy as state variables that describe the time-variation in investment opportunities. Using measures of uncertainty constructed from the state probabilities estimated from two-state regime-switching models of aggregate market return and of aggregate output, I find a negative relationship between the level of uncertainty and asset valuations. This relationship shows substantial cross-sectional variation across portfolios sorted on size, book-to-market, and past returns, especially conditional on the state of the economy. I show that a conditional model with investors' beliefs and an uncertainty risk factor is remarkably successful in explaining a large part of the cross-sectional variation in average portfolio returns. The uncertainty risk factor retains its incremental explanatory power when compared to other conditional models such as the conditional CAPM.
This paper is based on the first chapter of my dissertation at INSEAD. I would like to acknowledge helpful comments from Bernard Dumas, Michael Brandt, Alex Butler, Jennifer Conrad, Jose Miguel Gaspar, Eric Ghysels, Robert Kosowski, Anthony Lynch, Chris Lundblad, Massimo Massa, Ludo Phalippou, Anna Scherbina, Richard Stehle, and Lucie Tepla. Thanks also to the participants at the Western Finance Association Meetings, European Finance Association Meetings, Financial Management Assocation Meetings, Batten Young Scholars Conference at William & Mary, CEPR Gerzensee European Summer Symposium in Financial Markets, and to seminar participants at INSEAD, Queen's University, Drexel University, the University of Massachusetts at Amherst, Northeastern University, Tilburg University, the Analysis Group, and the Brattle Group. I am especially grateful to the editor, Joel Hasbrouck, and to an anonymous referee for many comments that greatly improved the paper. I thank the Western Finance Association and the Society of Quantitative Analysts for awarding this paper the SQA Award at the WFA Meetings in Vancouver. I thank the Financial Management Association for awarding this paper the 2004 Competitive Paper Award in the area of investments.