Returns on Cyclical and Defensive Stocks in Times of Scarce Information about the Business Cycle
43 Pages Posted: 12 Jun 2012 Last revised: 10 Apr 2013
Date Written: March 28, 2013
We study the implications of the quality of information about the business cycle for the pricing of defensive and cyclical stocks in a general equilibrium framework. We rely on a two-tree Lucas-style endowment economy in which the business cycle is modeled as an unobservable mean reverting process that influences one of the two assets. The representative Epstein-Zin investor learns about the latent business cycle variable from past dividends and from an additional signal. We find that expected excess returns on both cyclical and defensive stocks increase when information quality deteriorates, i.e. when the signal becomes more noisy. Variance reacts in an asymmetric way: a lower information quality induces a higher return variance of cyclical stocks and a lower return variance of defensive stocks. These findings are in line with stylized facts from the data when we use the dispersion in analysts' GDP forecasts as a measure for information quality.
Keywords: Asset Pricing, Epstein-Zin utility, Lucas Orchard, Learning, Information Quality
JEL Classification: G12
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