Predictability Concentrates in Bad Times. And so Does Disagreement
26 Pages Posted: 15 May 2019 Last revised: 26 Jun 2019
Date Written: June 25, 2019
Within a standard risk-based asset pricing framework with rational expectations, realized returns have two components: Predictable risk premiums and unpredictable shocks. In bad times, the price of risk increases. Hence, the predictable fraction of returns - and predictability - increases. "Disagreement" (dispersion in analyst forecasts) also intensifies in bad times if (i) analysts report (close to) risk-neutral expectations weighted by state prices, which become more volatile, or (ii) dividend volatility changes with the price of risk - for example, because consumption volatility changes. In both cases, individual analysts produce unbiased forecasts based on partial information.
Keywords: predictability, bad times, efficient market hypothesis, disagreement, rational expectations
JEL Classification: G11, G12, G14
Suggested Citation: Suggested Citation