STOCK NOW What REALLY drives stock market returns

What REALLY drives stock market returns


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First, a cry of anguish. Even by the standards of economic academia, this synopsis is a world-class word salad.

The paper reviews the evidence on the macroeconomic announcement premium and its implications on equilibrium asset pricing models. Empirically, a large fraction of the equity market risk premium is realized on a small number of trading days with significant macroeconomic announcements. We review the literature that demonstrates that the existence of the macroeconomic announcement premium implies that investors’ preferences must satisfy generalized risk sensitivity. We show how this conclusion generalizes to environments with heterogeneous investors and demonstrate how incorporating generalized risk sensitivity affects economic analysis in dynamic setups with uncertainty.

This is a shame, because the actual findings are fascinating. Since 1961, the ca 44 days a year where there has been major economic news account for over 71 per cent of aggregate equity market returns.

And over that period, the even smaller subset of Fed days are particularly powerful return boosters, as you can see in this table (zoomable version):

This isn’t entirely new — Pavel Savor and Mungo Wilson first showed a decade ago that employment, inflation, and interest rate news drives a surprising chunk of stock market returns. Since then many other economists have expanded on this, by focusing on elections and the Fed in particular, for example.

But in this paper, Hengjie Ai, Ravi Bansal and Hongye Guo review the entire historiography of the field, and show that the effect is actually growing larger rather than shrinking, which is what you’d normally see when the market cottons on to a weird, potentially profitable abnormality.

Specifically, from January 2020 to August 2023, the average announcement premium was 16.33 basis points per announcement, higher than the full sample average of 10.68 basis points.

This does make sense given the wild macroeconomic shenanigans we have been dealing with since the beginning of 2020. For example, for a decade inflation prints almost didn’t matter, and now they really really do. This is why macro hedge funds have generally enjoyed the last few years more than the preceding decade.

Ai, Bansal and Guo naturally suggest that economic news dominating stock market returns probably reflects a “compensation for risk”. Economic uncertainty is bad, clarity is good, so investors willing to carry a lot of risky positions going into an announcement need to be compensated for it.

Whatever the cause, the growing size of it is fascinating. Alphaville suspects it’s only a matter of time before some someone launches $FOMC, an ETF that simply goes 3x long stocks ahead of every major US economic news release, and short on market-neutral days.


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