Late to Recessions: Stocks and the Business Cycle (Job Market Paper)
Crowell Memorial Award for the Best Paper in Quantitative Investment, second prize.
2018 BlackRock Applied Research Award, finalist.
Presented at: Wharton, PanAgora Asset Management, BlackRock
I show that the state of the business cycle is far more informative about expected stock returns than previously recognized. I identify business-cycle turning points by estimating a state-space model using real-time macroeconomic and financial data. I find that returns are predictably negative for the first 4-6 months after the onset of recessions, and only become high thereafter. Moreover, returns exhibit substantial momentum in recessions, whereas in expansions they display the mild reversals expected from discount rate changes. A market timing strategy that optimally exploits these returns' business-cycle dependence produces a 60% increase in the buy-and-hold Sharpe ratio and substantially outperforms popular timing strategies in out-of-sample tests. In contrast with previous literature, the predictability is mostly due to the macro quantities. Using investor forecast surveys, I show that my findings are consistent with investors' slow reaction to recessions.
R&R at Review of Financial Studies
Less than you think. Macro-finance term structure models rely too heavily on the volatility of expected inflation news as a source for variations in nominal yield shocks. This paper develops and estimates a model featuring inflation non-neutrality and preference shocks. Stochastic volatility of inflation and consumption govern bond risk premia movements, while preference shocks generate volatile nominal yields. The model accounts for key bond market features, without resorting to an overly dominating expected inflation channel. The estimation shows that preference shocks are correlated with market distress factors, and that in the last two decades, inflation-related risks played a secondary role.
Presented at: USC Marshall PhD Conference, 2018 ITAM Alumni Conference, Central Bank of Mexico 2017.
I extend the econometric framework of my job market paper by incorporating the information contained in a set of exogenous predictors (e.g., price-dividend ratios). Compared to standard predictive regressions, my framework allows for a state-dependent shrinkage in the predictive slope coefficient. During expansions, when expected returns do not fluctuate much, the predictive slope coefficient shrinks towards zero. In contrast, during recessions, the slope coefficient expands relative to the standard OLS estimate. In essence, my econometric framework allows for large breaks in model coefficients and ties them to business-cycle fluctuations. In contrast with previous literature, the results of this paper suggest that stock return predictability is neither a short-lived nor a recessionary phenomenon.