Recession fears as self-fulfilling prophecies? Influence on stock returns and output

Abstract

Market participants must rely upon probability assessments of the current state of the economy, that is, their rational ex-ante estimates of recession fears, when making financial and investment decisions. This paper explores whether ex-ante recession fears, modelled using probit analysis of coincident indicators, affect stock returns and output during recessions as well as upturns. Ex-ante recession fears are unrelated to stock returns, an unexpected result that is explained by the lead-lag relationship between recession turning points and subsequent stock market recoveries. Ex-ante recession fears have important dampening effects on output during and, especially, prior to recessions, thus suggesting that recession fears can potentially become self-fulfilling.