The role of economic uncertainty in the cross-sectional pattern of stock excess returns can be evaluated. Stocks with low uncertainty beta generate higher annualized risk-adjusted returns compared with stocks with high uncertainty beta. These findings are consistent with the view that investors are uncertainty averse and demand a premium to hold stocks whose returns are poor when economic uncertainty is high.
How Is This Research Useful for Practitioners?
The authors investigate the role of economic uncertainty in the cross-sectional pricing of individual stocks and portfolios. The reasoning behind such a relationship is that an increase in economic uncertainty makes investors nervous about the future and causes them to reduce consumption and investment demand to save more in order to hedge against possible bad future economic outcomes. Investors will also prefer holding stocks whose returns increase when economic uncertainty increases. Therefore, uncertainty-averse investors are willing to pay higher prices (and accept lower returns) for stocks with higher “uncertainty beta.”
Consistent with these theoretical predictions, the authors find that investors demand a premium to hold stocks with negative uncertainty beta. Specifically, they find that low uncertainty beta stocks generate 6.1% higher annualized risk-adjusted returns than high uncertainty beta stocks. In addition, the uncertainty beta helps predict future returns up to 11 months ahead. The authors also find that the uncertainty premium is significantly higher during economic downturns and periods of high economic uncertainty.
How Did the Authors Conduct This Research?
The authors estimate the uncertainty beta for each stock trading on the NYSE, AMEX, and NASDAQ. This economic uncertainty index is the conditional volatility of the unforecastable component of many economic indicators. A stock’s uncertainty beta is estimated each month using a 60-month trailing regression of its excess returns on the uncertainty index. Next, by sorting individual stocks each month into decile portfolios by their uncertainty beta, the authors examine the performance of the uncertainty beta to explain next month’s cross-sectional stock returns. The authors’ sample period is from July 1977 to December 2014.
Examining the characteristics of stocks with low and high uncertainty beta, the authors find that high uncertainty beta stocks tend to be large, liquid growth stocks, while low uncertainty beta stocks tend to be small, illiquid value stocks. After controlling for a wide variety of stock characteristics and factors, the authors show that a stock’s return in the next month loads negatively, and significantly, on the stock’s uncertainty beta. In fact, they show that a stock’s uncertainty beta this month helps predict its excess returns 11 months ahead.
Next, the authors run a battery of additional tests. They investigate the significance of nonlinearity and time-series variation in the uncertainty premium. They also test the robustness of their main finding using the equity portfolios, instead of individual stocks, as test assets. Checks are consistent with their main finding that there is a significant negative relationship between the uncertainty beta and future stock returns.
Abstractor’s Viewpoint
The authors provide robust empirical support for the pricing of uncertainty in the cross section of stock returns. I find the predictive power of the uncertainty beta lasting for 11 months one of the more interesting findings. It is unclear whether such predictive power can be exploited by profit-seeking investors. The answer to that issue would be an interesting topic for future research.