When investors think about the risk of investing in the stock market, one of the things they pay attention to is how stocks and the underlying earnings of companies are affected by movements in the economy. Stocks that closely follow the ups and downs of business cycles are considered riskier, because these stocks will typically fall at the first hint of a downturn and rise faster as the economy recovers. From the investors' perspective, then, stocks of companies whose earnings are most affected by economic conditions should promise a bigger return.
The high returns observed in the stock market would therefore suggest that its performance is strongly related to business cycles. Indeed, many people think that an economic recession goes hand in hand with a bear market. However, Chicago Booth professor John Heaton says this often has not been true in the past. "There have been a lot of settings where stocks have come down but the economy has not moved," says Heaton. Why, then, would investors demand high risk premiums in the stock market?
Perhaps equally baffling is why value stocks, which are stocks with low market values relative to the fundamental factors that determine their price, have had consistently higher returns than growth stocks, which are stocks whose earnings are expected to grow rapidly. This difference in average returns arises even though the returns on both types of portfolios are about equally correlated with business cycles. It is unclear from simply looking at the correlation between the returns of different portfolios and the state of the economy why investors would ask for a higher return for holding value stocks.
These puzzling observations have overlooked the fact that investors are concerned not only about the impact of short-term fluctuations in business cycles on stock prices, but also about how an uncertain economic future might affect their investments, according to a recent paper by Heaton, Lars Peter Hansen, a professor in the Department of Economics at the University of Chicago, and Nan Li, a professor at National University of Singapore, titled "Consumption Strikes Back? Measuring Long-Run Risk." In particular, a decline in the stock market today may reflect an underlying shock to the economy that will not dissipate quickly and will have an impact over a long horizon.
"Maybe what's really happening is that when the stock market goes down today, investors think that this is telling them a lot about the state of the economy in the future," Heaton says. If investors perceive that economic conditions will be worse in the future then investors will likely ask for a higher return on stocks today to compensate them for that higher risk.
Measuring Long-Run Risk
Hansen, Heaton, and Li develop a theory that captures long-run risk, or the risk that arises from the uncertainty about the long-run growth of the economy. They show also how to appropriately measure the relationship between current stock market returns and future economic conditions—a relationship that leads to differences in required returns. Under this theory, stocks that have higher predicted required returns should have lower prices to reflect the additional return needed to persuade investors to buy those stocks.
An economic downturn can raise uncertainty about the pace of future economic growth in several ways. For instance, a number of people who lose their jobs in a recession will not find work again and will leave the labor force, permanently reducing the economy's productive capacity. Other bad shocks that investors may see as threats to future economic growth include a widening government deficit that raises the prospect of higher taxes in the future or a recession that makes politicians feel more protectionist in terms of international trade. As a result, a recession today can make investors think hard about the risk that the economy may no longer return to its long-run growth path.
Hansen, Heaton, and Li use their theory to understand whether an exposure to long-run risk can help explain the difference in returns of value and growth portfolios. In particular, if the cash flows generated by value stocks are more highly correlated with future economic conditions compared with those of growth stocks, then investors would demand a higher return to hold a value portfolio that they perceive to have a higher exposure to long-run risk.
Indeed, the study finds that the cash flows of value portfolios are strongly correlated in the long run with macroeconomic shocks, while growth portfolios show little correlation. The results confirm the authors' argument that investors are concerned not just about the short-term impact of business fluctuations but also about how these disturbances will affect economic prospects years from now. Investors see the long run as an important source of risk, which they consider when accepting a price for the assets they buy.
Consumption Makes a Comeback
Before Hansen, Heaton and Li's study, researchers had somewhat abandoned the idea that stock prices largely reflect the relationship between the aggregate economy and the stock market. The economic models that researchers typically use did not adequately explain the consistently high equity premiums observed in the data, leading academics toward behavioral biases and transactions costs to account for this shortcoming.
But by figuring out how to accurately measure long-run risk, Hansen, Heaton, and Li have made it possible for fundamental economic variables to once again play a key role in determining asset prices. That's the story behind the paper's title. "What we're saying is that using fundamentals like consumption to measure risk can actually work if you look at a longer horizon," says Heaton.
Consumption is the largest component of gross domestic product and is an important indicator of economic well-being. By looking at the correlation between stock returns and expected future consumption, Hansen, Heaton, and Li were able to come up with a measure of long-run risk that—when linked to the economic shocks that investors see today— proves that fundamentals can indeed drive risk premiums in the stock market.
John C. Heaton is a Joseph L. Gidwitz Professor of Finance.