Business cycle and herding behavior in stock returns: theory and evidence

Abstract

This study explains the role of economic uncertainty as a bridge between business cycles and investors’ herding behavior. Starting with a conventional stochastic differential equation representing the evolution of stock returns, we provide a simple theoretical model and empirically demonstrate it. Specifically, the growth rate of gross domestic product and the power law exponent are used as proxies for business cycles and herding behavior, respectively. We find stronger herding behavior during recessions than during booms. We attribute this to economic uncertainty, which leads to strong behavioral bias in the stock market. These findings are consistent with the predictions of the quantum model.