The Influence on the Trending of Stocks During Periods of Economic Growth and Downturn

Abstract

How do business cycles leave their mark on the stock market? This paper tackles this question by weaving together three empirical threads: Markov Regime Switching (MRS) to identify economic states, Vector Autoregression (VAR) to trace shock transmission, and GARCH models to capture volatility dynamics. Our analysis of U.S. data (1990-2024) reveals a clear, state-dependent narrative. Expansions are not just periods of higher equity returns; they are also characterized by a calmer market environment. In contrast, recessions deliver a dual blow: significantly lower returns and volatility that is both higher and more stubborn. Perhaps most critically, we find that the stock market’s sensitivity to macroeconomic shocks intensifies during downturns—a negative output shock or a tightening of financial conditions packs a stronger and more prolonged punch. These core findings prove resilient across a battery of robustness checks, from swapping in alternative cycle indicators like the CFNAI to examining industry-level data. The practical implication is straightforward: ignoring the business cycle is a risky strategy for both portfolio management and macroeconomic stabilization.