Long-term volatility shapes the stock market’s sensitivity to news

We show that the S&P 500’s instantaneous response to surprises in U.S. macroeconomic announcements depends on the level of long-term stock market volatility. When long-term volatility is high, stock returns are more sensitive to news, and there is a pronounced asymmetry in the response to good and bad news. We explain this by combining the Campbell–Shiller log-linear present value framework with a two-component volatility model for the conditional variance of cash flow news and allowing for volatility feedback. In our model, innovations to the long-term volatility component are the most important driver of discount rate news. Large announcement surprises lead to upward revisions in future required returns, which dampen/amplify the effect of good/bad news.