Business-Cycle Pattern of Asset Returns: A General Equilibrium Explanation

Abstract

I develop an analytical general-equilibrium model to explain economic sources of business-cycle pattern of aggregate stock market returns. With concave production functions and capital accumulation, a technology shock has a pro-cyclical direct effect and a counter-cyclical indirect effect on expected returns. The indirect effect, reflecting the "feedback" effect of consumers' behavior on asset returns, dominates the direct effect and causes counter-cyclical variations of expected returns. I show that the conditional mean, volatility, and Sharpe ratios of asset returns all vary counter-cyclically and they are persistent and predictable, and that stock market behavior has forecasting power for real economic activity.

Keywords: counter-cyclical variation, capital accumulation, decreasing returns to capital, overlapping-generation model

JEL Classification: D51, E30, G11, G12