The sensitivity of Fama-French factors to economic uncertainty

This paper analyzes the sensitivity of the three Fama-French factors in relation to the US economic uncertainty, by using three proxies of uncertainty measures in macroeconomics, financial markets or economic policy from January 1985 to December 2011. We examine the extent, speed and duration of response of the three (market, size and value) risk premia to movements in the US uncertainties under low and high volatility regimes through the Markov-regime switching VAR model. We find clearly two (high and low) volatility regimes, where each regime is highly persistent. The high volatility regime is the prevailing regime between periods of 2000 to 2003, and 2008 to the end of 2012. We show a negative effect of changes in financial and economic policy uncertainties on value risk premia during the high volatility regime. This finding imply that investors move to growth stocks from value stocks in high volatility regime when volatility is expected to increase. The latter suggests that value firms can be more risky than growth firms during high volatility periods. We also propose an aggregate measure of economic uncertainty by using Principal Component Analysis based on the three uncertainty proxies. The results on value risk premia are confirmed. We find a negative relationship between the market risk premium and the change in the economic uncertainty index in high volatility regime. Finally, by adding a liquidity risk factor we find a positive effect of financial uncertainty on liquidity factor during the high volatility regime, suggesting that investors preferring liquidity stocks when market uncertainty increases.