Rare Events, Financial Crises, and the Cross-Section of Asset Returns

Similarities between the Great Depression and the Great Recession are documented with respect to the behavior of financial markets. A Great Depression regime is identified by using a Markov-switching VAR. The probability of this regime has remained close to zero for many decades, but spiked for a short period during the most recent financial crisis, the Great Recession. The Great Depression regime implies a collapse of the stock market, with small-growth stocks outperforming small-value stocks. This helps to explain the cross section of asset returns when risk is priced according to a version of the "Bad Beta, Good Beta" Intertemporal CAPM that allows for regime changes.