Knowledge that Transforms

In this article we break assets’ betas with common factors into components attributable to news about future cash flows, real interest rates, and excess returns. To achieve this decomposition, we use a vector autoregressive time-series model and an approximate log-linear present value relation. The betas of industry and size portfolios with the market are largely attributed to changing expected returns. Betas with inflation and industrial production reflect opposing cash flow and expected return effects. We also show how asset pricing theory restricts the expected excess return components of betas.

Previous research finds that fundamental macroeconomic news has little effect on stock prices. We show that after allowing for different stages of the business cycle, a stronger relationship between stock prices and news is evident. In addition to stock prices, we examine the effect of real activity news on proxies for expected cash flows and equity discount rates. We find that when the economy is strong the stock market responds negatively to news about higher real economic activity. This negative relation is caused by the larger increase in discount rates relative to expected cash flows.