Dissertation/Thesis Abstract

Equity Market Returns and Recessions
by Guan, Jingling, Ph.D., Northwestern University, 2011, 125; 3469725
Abstract (Summary)

In this thesis, I empirically investigate the relations between recessions and the cross-section and aggregate equity returns. Chapter 1 investigates the relation between recessions and the cross-section of stock returns. I find that a stock's exposure to recession risk is an important determinant for its expected returns. I develop a new method to estimate the recession risk exposure of individual stocks using financial statement information, such as profitability and leverage. I construct a recession score based on common financial ratios and find that firms with scores in the safest decile earn 13% per year more during recessions than firms in the most risky decile. The portfolios generated by sorting on recession scores highlight exposure to recession risk and make good candidates to test linear asset pricing models. I find that while both the Fama-French three-factor model and the consumption-based CAPM can explain the cross-section of returns on these recession score portfolios, the CAPM cannot. Chapter 2 reviews the literature on the predictability of the equity premium. In Chapter 3, I use recessions to predict the aggregate equity premium. First, I use the Stock and Watson (1989) model for forecasting recessions and the pre-sample of return patterns across the business cycles to build a nonlinear model that categorizes each month into a boom, collapse, or recovery period. Second, I use this prediction to forecast the equity premium. Estimating this model in real time only using information prior to the forecast month, I make economically and statistically significant predictions of the equity premium. Using this model, an investor can quadruple the cumulative return of holding the S&P 500 index portfolio by avoiding the collapse periods predicted by the model. I conclude that forecasting macroeconomic conditions is a useful approach to forecasting excess returns in real time.

Indexing (document details)
Advisor: Jagannathan, Ravi, Parker, Jonathan
Commitee: Christiano, Lawrence, Sapienza, Paola, Van Binsbergen, Jules
School: Northwestern University
Department: Finance
School Location: United States -- Illinois
Source: DAI-A 72/12, Dissertation Abstracts International
Subjects: Finance
Keywords: Cross-section returns, Equity markets, Predictability, Recessions, Stock market returns, Systematic risk
Publication Number: 3469725
ISBN: 978-1-124-86036-7
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