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Structural Shocks, Business Condition Expectations, and Expected Stock Market Returns

Through the interaction terms of business condition expectations and structural shocks, the non-linear effects of business condition expectations on expected stock market returns were studied. We found that the recession expectation enlarges the positive effects of a permanent shock on the expected stock market return, and also increases the negative impacts of the temporary shock. Over the long-horizon forecast, these effects increase over time. Moreover, the impacts under the recession expectation are greater than those under the expansion expectation. The results are robust and have economic significance. We also provide evidence for the existence of a negative relationship between business condition expectations and expected stock market returns.