TAILIEUCHUNG - STOCK MARKET OVERREACTION TO BAD NEWS IN GOOD TIMES: A RATIONAL EXPECTATIONS EQUILIBRIUM MODEL

The model used–an extension of the log-linear dividend-price ratio model of Campbell and Shiller (1988, 1989)–facilitates a straightforward test of these alternatives in a linear regression with the log price-earnings ratio as dependent variable. The regression results suggest that the correlation between the price-earnings ratio and expected inflation is the result of both effects; that is, an increase in expected inflation reduces equity prices because it is associated with both lower expected real earnings growth and higher required real returns. Surprisingly, the results do not suggest that the earnings channel is merely a reflection of inflation’s recession- signaling properties. . | Stock Market Overreaction to Bad News in Good Times A Rational Expectations Equilibrium Model Pietro Veronesi University of Chicago This article presents a dynamic rational expectations equilibrium model of asset prices where the drift of fundamentals dividends shifts between two unobservable states at random times. I show that in equilibrium investors willingness to hedge against changes in their own uncertainty on the true state makes stock prices overreact to bad news in good times and underreact to good news in bad times. I then show that this model is better able than conventional models with no regime shifts to explain features of stock returns including volatility clustering leverage effects excess volatility and time-varying expected returns. One of the most interesting aspects of financial data series is that stock return volatility changes widely across time. Historically the monthly volatility of stock returns has been as high as 20 in the early 1930s and as low as 2 in the early 1960s see Figure 1 . Moreover changes in return volatility tend to be persistent giving rise to the well-documented volatility clustering and GARCH-type behavior of returns see . Bollerslev Chou and Kroner 1992 for an excellent survey of the literature . Even though the statistical properties of return volatility have been deeply studied and uncovered by financial economists several questions remain regarding their economic explanation. For example why does return volatility tend to be higher in recessions One explanation offered in the literature is that during recessions firms riskiness is higher because they have higher debt-equity ratios see Black 1976 . However evidence reported by Sch-wert 1989 shows that this cannot be the whole story. Indeed recent research has shown that investors uncertainty over some important factors affecting the economy may greatly impact the volatility of stock returns. Bittlingmayer 1998 for instance argues that return volatility is related to

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