Revealing Downturns

When Bayesian risk-averse investors are uncertain about their assets’ cash flows’ exposure to systematic risk, stock prices react to news more in downturns than in upturns, implying higher volatility in downturns and negatively skewed returns. In good times, less desirable assets with low average cash flows and high market risk perform similar to more desirable assets with high average cash flows and low market risk, rendering them difficult to distinguish. However, their 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.