Long-Term Volatility Shapes the Stock Market's Sensitivity to News

Abstract

We show that the S&P 500's instantaneous response to surprises in U.S. macroeconomic announcements depends on the level of long-term stock market volatility. When long-term volatility is high, stock returns are more sensitive to news, and there is a pronounced asymmetry in the response to good and bad news. We explain this by combining the Campbell-Shiller log-linear present value framework with a two-component volatility model for the conditional variance of cash flow news and allowing for volatility feedback. In our model, innovations to the long-term volatility component are the most important driver of discount rate news. Large announcement surprises lead to upward revisions in future required returns, which dampens/amplifies the effect of good/bad news.

Keywords: Event study, long- and short-term volatility, macroeconomic announcements, stock market response, time-varying risk premia, volatility feedback effect

JEL Classification: C58, E44, G12, G14