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Abstract
Based on a generalization of the Campbell and Shiller (1988) approach to a framework with regime-switching parameters and variances, we analyze the decomposition of S&P 500 returns into cash flow and discount rate news over the business cycle while distinguishing between conditional and unconditional variances. We find that discount rate news is more important than cash flow news in determining the conditional variance of returns in recessions while the opposite holds in expansions. In an asset pricing model with regime-switching fundamentals, the fact that discount rate news is more sensitive to changes in investors’ beliefs, which are more volatile in recessions, provides a potential explanation.
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