A Tale of Fear and Euphoria in the Stock Market

Hui Guo, Qian Lin and Yujou Pai

Journal of Financial and Quantitative Analysis, 2025, vol. 60, issue 4, 1797-1826

Abstract: We propose a consumption-based model to explain puzzling unstable (i.e., sometimes positive and sometimes negative) relations between stock market variance with both stock market risk premia and prices. In the model, market risk premia depend positively (negatively) on fear (euphoria) variance. Market prices, which decrease with discount rates, correlate negatively (positively) with fear (euphoria) variance. Because it is the sum of fear and euphoria variances, the market variance may correlate positively or negatively with expected returns and prices, depending on the relative importance of the two variances. Our empirical results support the model’s key assumptions and many novel implications.

Date: 2025
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