Essays in Asset Pricing

In the first chapter, Late to Recessions: Stocks and the Business Cycle , I show that the state of the business cycle is far more informative about expected stock returns than previously recognized. I identify business-cycle turning points by estimating a state-space model using real-time macroeconomic and financial data. I find that returns are predictably negative for the first 4–6 months after the onset of recessions, and only become high thereafter. Moreover, returns exhibit substantial momentum in recessions, whereas in expansions they display the mild reversals expected from discount rate changes. A market timing strategy that optimally exploits these returns\u27 business-cycle dependence produces a 60 increase in the buy-and-hold Sharpe ratio and substantially outperforms popular timing strategies in out-of-sample tests. In contrast with previous literature, the predictability is mostly due to the macro quantities. Using investor forecast surveys, I show that my findings are consistent with investors\u27 slow reaction to recessions. The second chapter, How Important are Inflation Expectations for the Nominal Yield Curve? , co-authored with Amir Yaron, develops and estimates a nonlinear Bayesian state-space macro-finance model featuring inflation non-neutrality, as well as (preference) demand shocks. Stochastic volatility of inflation and consumption govern time variation in bond risk premia, while demand shocks primarily affect variation in bond yields. These channels allow the model to account for key bond market features, without resorting to an expected inflation channel that overly dominates the variation in nominal yield shocks. The estimated preference shocks seem to be associated with market illiquidity and distress factors