This paper evaluates whether economic uncertainty is consistent with the Merton (1973) intertemporal CAPM (ICAPM) theory. The economic uncertainty index of Jurado, Ludvigson and Ng (2015) consistently predicts a significant increase in stock market volatility. However, its innovation carries a statistically insignificant price of covariance risk in the cross-section, thereby failing to satisfy the Maio and Santa-Clara (2012) sign restrictions associated with the ICAPM. I also find robust evidence by using the level of the economic uncertainty index (JEL G10, G11, G12). Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

In this paper, we test the consistency of the q5 model of Hou et al. (2019, 2020) with Merton’s (1973) intertemporal capital asset pricing model (ICAPM) framework. We find that all but one factors in the q5 model carry significantly positive covariance risk prices. The profitability factor, however, has little explanatory power for the cross-section of expected returns. The time-series tests show that the investment factor predicts a significant decline in stock market volatility, thereby being consistent with its positive price of covariance risk and satisfying the sign restrictions associated with the ICAPM. Importantly, the expected growth factor that is found to be helpful in describing cross-sectional average returns fails to predict future investment opportunities with the correct sign, which indicates that it is not a valid risk factor under the ICAPM. Overall, the ICAPM cannot be used as a theoretical background for the q5 model.