Discussion paper

DP12597 Revealing Downturns

When Bayesian risk-averse investors are uncertain about their assets'
cash flows' exposure to systematic risk, stock prices react more to
news in downturns than in upturns, implying higher volatility in downturns
and negatively skewed returns. The reason is that, in good times,
less desirable assets with low average cash flows and high loading
on market risk perform similar to more desirable assets with high
average cash flows and low market risk, rendering them difficult to
distinguish. However, their relative fundamental performance diverges
in downturns, enabling better inference. Consistent with these predictions,
stocks' reaction to earnings news is up to 70% stronger in downturns
than in upturns.


Schmalz, M (2018), ‘DP12597 Revealing Downturns‘, CEPR Discussion Paper No. 12597. CEPR Press, Paris & London. https://cepr.org/publications/dp12597