Working Paper: NBER ID: w16222
Authors: John Y. Campbell; Stefano Giglio; Christopher Polk
Abstract: This paper shows that the stock market downturns of 2000-2002 and 2007-09 have very different proximate causes. The early 2000's saw a large increase in the discount rates applied to corporate profits by rational investors, while the late 2000's saw a decrease in rational expectations of future profits. In each case the downturn reversed the trends of the previous boom. We reach these conclusions using a vector autoregressive model of aggregate stock returns and valuations, estimated imposing the cross-sectional restrictions of the intertemporal capital asset pricing model (ICAPM). As stock returns are very noisy, exploiting an economic model such as the ICAPM to extract information about future corporate profits from realized returns can potentially be very useful. We confirm that the ICAPM restrictions improve the out-of-sample forecasting performance of VAR models for stock returns, and that our conclusions are consistent with a simple graphical data analysis. Our findings imply that the 2007-09 downturn was particularly serious for rational long-term investors, who did not expect a strong recovery of stock prices as they did earlier in the decade.
Keywords: No keywords provided
JEL Codes: G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| different nature of downturns (E32) | different implications for expectations of future stock returns (G17) |
| increase in discount rates (E43) | stock market downturn 2000-2002 (G10) |
| decrease in rational expectations of future profits (D84) | stock market downturn 2007-2009 (G10) |
| heightened aggregate risk (D80) | increase in discount rates (E43) |
| increased risk aversion among investors (G41) | increase in discount rates (E43) |
| transfer of risk from irrational to rational investors (G11) | increase in discount rates (E43) |
| worsening cash flow prospects (G33) | stock market downturn 2007-2009 (G10) |
| minimal role of discount rates (E43) | stock market downturn 2007-2009 (G10) |