This article presents a dynamic, rational expectations equilibrium model of asset prices where the drift of fundamentals (dividends) shifts between two unobservable states at random times. I show that in equilibrium, investors' willingness to hedge against changes in their own "uncertainty" on the true state makes stock prices overreact to bad news in good times and underreact to good news in bad times. I then show that this model is better able than conventional models with no regime shifts to explain features of stock returns, including volatility clustering, "leverage effects," excess volatility, and time-varying expected returns.

[This article presents a dynamic, rational expectations equilibrium model of asset prices where the drift of fundamentals (dividends) shifts between two unobservable states at random times. I show that in equilibrium, investors' willingness to hedge against changes in their own "uncertainty" on the true state makes stock prices overreact to bad news in good times and underreact to good news in bad times. I then show that this model is better able than conventional models with no regime shifts to explain features of stock returns, including volatility clustering, "leverage effects," excess volatility, and time-varying expected returns.]

Using a simple dynamic asset pricing model, this paper investigates the relationship between the precision of public information about economic growth and stock market returns. After fully characterizing expected returns and conditional volatility, I show that (i) higher precision of signals tends to increase the risk premium, (ii) when signals are imprecise the equity premium is bounded above independently of investors' risk aversion, (iii) return volatility is U‐shaped with respect to investors' risk aversion, and (iv) the relationship between conditional expected returns and conditional variance is ambiguous.

A frictionless general equilibrium model featuring heterogeneous time-varying risk tolerance explains the business cycle dynamics of intermediary leverage, aggregate credit, and other asset markets’ facts. In booms, when risk tolerance is high, households borrow more and aggregate credit increases funded by higher intermediary debt. In recessions, credit contracts and intermediaries delever. Yet, their debt-to-equity ratios increase as equity drops when risk aversion increases. Because households borrow more or less as their risk tolerance increases or decreases, the intermediary’s balance sheet forecasts stock returns both in the time series and the cross section. Moreover, credit expansions correlate with negatively skewed stock returns, low credit spreads, and predict lower future returns.

Non-linear external habit persistence models, which feature prominently in the recent “equity premium” asset pricing and macroeconomics literature, generate counterfactual predictions in the cross-section of stock returns. In particular, we show that in the absence of cross-sectional heterogeneity in firms’ cash-flow risk, these models produce a “growth premium,” that is, stocks with high price-to-fundamental ratios command a higher premium than stocks with low price-to-fundamental ratios. This implication is at odds with the well-established empirical observation of a “value premium” in the cross-section of stock returns. Substantial heterogeneity in firms’ cash-flow risk yields both a value premium as well as most of the stylized facts about the cross-section of stock returns, but it generates a “cash-flow risk puzzle”: Quantitatively, value stocks have to have “too much” cash-flow risk compared to the data to generate empirically plausible value premiums.

Shocks to equity options' implied volatility are followed by persistently lower short-term rates. Shocks to puts' over calls' out-of-the-money implied volatilities (P/C) are followed by persistently higher rates. Stock and Treasury bond implied volatilities, which measure market and policy uncertainty, are countercyclical, while P/C, which measures downside risk, is procyclical. An equilibrium model in which investors and the central bank learn about composite regimes of economic and policy variables explains these dynamics, linking them to a learning-based, forward-looking Taylor rule. Survey data support our model's predictions on the effect of uncertainty on the level and fluctuations of implied volatilities.

We propose a novel economic mechanism that generates stock return predictability in both the time series and the cross-section. Investors' income has two sources, wages and dividends that grow stochastically over time. As a consequence the fraction of total income produced by wages fluctuates depending on economic conditions. We show that the risk premium that investors require to hold stocks varies with these fluctuations. A regression of stock returns on lagged values of the labor income to consumption ratio produces statistically significant coefficients and large adjusted R2s. Tests of the model's cross-sectional predictions on the set of 25 Fama-French portfolios sorted on size and book-to-market are also met with considerable support.

We propose a novel economic mechanism that generates stock return predictability in both the time series and the cross-section. Investors’ income has two sources, wages and dividends that grow stochastically over time. As a consequence the fraction of total income produced by wages fluctuates depending on economic conditions. We show that the risk premium that investors require to hold stocks varies with these fluctuations. A regression of stock returns on lagged values of the labor income to consumption ratio produces statistically significant coefficients and large adjusted R2s. Tests of the model’s cross-sectional predictions on the set of 25 Fama–French portfolios sorted on size and book-to-market are also met with considerable support.

We analyze how changes in government policy affect stock prices. Our general equilibrium model features uncertainty about government policy and a government whose decisions have both economic and noneconomic motives. The model makes numerous empirical predictions. Stock prices should fall at the announcement of a policy change, on average. The price decline should be large if uncertainty about government policy is large, and also if the policy change is preceded by a short or shallow economic downturn. Policy changes should increase volatilities and correlations among stocks. The jump risk premium associated with policy decisions should be positive, on average.