Good Times or Bad Times? Investors\u27 Uncertainty and Stock Returns

This paper investigates empirically the dynamics of investors\u27 beliefs and Bayesian uncertainty on the state of the economy as state variables that describes the time-variation in investment opportunities. Using measures of uncertainty constructed from the state probabilities estimated from two-state regime-switching regime models of aggregate market return, and of aggregate output, I find a negative relationship between the level of uncertainty and asset valuations. This relationship shows substantial cross-sectional variation across portfolios sorted on size, book-to-market and past returns, especially conditional on the state of the economy. I show that a conditional model with investors\u27 beliefs and uncertainty risk factor, is remarkably successful in explaining a large part of the cross-sectional variation in average portfolio returns. The uncertainty risk factor retains its incremental explanatory power when contrasted with other economically-motivated factors such as GDP news, or other conditional models such as (C)CAPM