Term Structure of Disagreement and Predictability Over the Business Cycle
52 Pages Posted: 19 Nov 2015
Date Written: June 1, 2014
Our objective is to identify the mechanism that causes return predictability to vary over the business cycle and the trading strategy that allows an investor to take advantage of it. We build an equilibrium model in which some investors believe the economy transits slowly from good to bad times, while others believe economic conditions can change precipitately. This particular type of heterogeneous beliefs leads to a time-varying term structure of disagreement whereby return predictability rises as economic conditions deteriorate. In bad times, disagreement spikes in the short term, generating short-term momentum followed by a long-term reversion to fundamentals. In good times, instead, disagreement is steady and therefore prices revert instantly to fundamentals. Investors implement momentum strategies to extract momentum in bad times and time the market to avoid momentum crashes when the market rebounds.
Keywords: Asset Pricing, Learning, Term Structure of Disagreement, Business Cycle, Predictability, Times-Series Momentum, Momentum Crashes
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