Hui Guo, Chaojiang Wu, and Yan Yu
We model conditional market beta and alpha as flexible functions of state variables identified via a formal variable selection procedure. In the post-1963 sample, beta of the value premium comoves strongly with unemployment, inflation, and price-earnings ratio in a countercyclical manner. We also uncover a novel nonlinear dependence of alpha on business conditions: It falls sharply and even becomes negative during severe economic downturns but is positive and flat otherwise. The conditional CAPM performs better than the unconditional CAPM but this does not fully explain the value premium. Our findings are consistent with a conditional CAPM with rare disasters.