Measuring Long-Run Risk

John C. Heaton, professor of Finance at the University of Chicago Booth School of Business, discusses what happens when "consumption strikes back" and how fundamental economic variables regain importance in explaining risk premiums in stock markets. He also discusses how a decline in the stock market today may reflect an underlying shock to the economy that will not dissipate quickly and will have an impact over a long horizon.

Stocks that closely follow business cycles are considered riskier, because they will typically fall at the first hint of a downturn and rise faster as the economy recovers. From the investors' perspective, stocks of companies whose earnings are most affected by economic conditions should promise a bigger return.

Many people then believe that an economic recession goes hand in hand with a bear market. However, Heaton says this often has not been true in the past, and value stocks, those with low market values relative to the fundamental factors that determine their price, have had consistently higher returns than growth stocks, those whose earnings are expected to grow rapidly.