The volatility of consumption-based stochastic discount factors and economic cycles

Recession fears as self-fulfilling prophecies? Influence on stock returns and output

“…The paper therefore contributes, both in its approach and its results, to an increasing interest in the finance literature as to whether recessions and ex-ante recession fears have differential effects on financial and output markets during downturns versus upturns (see, e.g. Boyd et al, 2005;Henkel et al, 2007;Nieto and Rubio, 2008).…”

“…He and Ng, 1998). An Inverse Mill's ratio IM t interaction variable is used to capture the influence of exante recession fears on returns and output during recessions, as well as during upturns or just prior to recessions (see Boyd et al, 2005;Henkel et al, 2007;Nieto and Rubio, 2008). 9 These effects are estimated using an interaction variable that employs the ex-post recession dummy variable BC t as follows:…”

“…Table 4(a) reveals that there is a very strong overall negative relationship between ex-ante recession fears and industrial production growth (IP t ), since the t-statistics for the recession fear Inverse Mill's Ratio (IM t ) coefficient are well above the 95% bootstrapped t-statistic cut-off values reported in Panels D-F. To emphasize the strength of this result, it can be noted that the Table 4(a) adjusted R 2 values imply that ex-ante recessions fears explain almost twice as much of the variability of industrial production growth rates (IP), on their own, than does the ex-post NBER recession indicator BC t (compare Panel C of Table 2 with Panel F of Table 4(a)). Although the approaches are not necessarily directly comparable (due to differing time series properties), ex-ante recession fears that are estimated using ex-ante recession probability assessment model (1) also appear to have much stronger power for explaining industrial production growth rates than do recession fears that are estimated using stochastic discount factors (compare Panels D-F of Table 4(a) with Table 3 of Nieto and Rubio (2008)). …”

“…This result could be due to the empirical relationship being asymmetric during recessions versus non-recessions, however, thus obscuring the overall relationship between ex-ante recession fears and real stock returns. Boyd et al (2005) find, for instance, that the stock market reacts negatively to unemployment rate increase surprises when there is a high likelihood of a recession, and positively otherwise, thus suggesting it is possible that the relationship between ex-ante recession fears and stock returns is asymmetric (see also Henkel et al, 2007;Nieto and Rubio, 2008).…”

“…This is especially important for understanding the relationship between ex-ante recession fears and stock returns, since it is possible that ex-ante recession fears might only be important to the stock market as the economy enters a recession (see Boyd et al, 2005;Henkel et al, 2007;Nieto and Rubio, 2008). Boyd et al (2005), for instance, examine whether investors react differently to unemployment news surprises when they perceive that the economy is in a recession, versus whether they perceive an upturn is occurring, and find that an increase in unemployment is only bad news for the stock market during recessions.…”