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The Declining Equity Premium: What Role Does Macroeconomic Risk Play?

Martin Lettau^1,2,3,4; Sydney C. Ludvigson^1,2,3,4; Jessica A. Wachter^1,2,3,4

¹ National Bureau of Economic Research · ² Mercer University · ³ Center for Interuniversity Research and Analysis on Organizations · ⁴ New York University

Aggregate stock prices, relative to virtually any indicator of fundamental value, soared to unprecedented levels in the 1990s. Even today, after the market declines since 2000, they remain well above historical norms. Why? We consider one particular explanation: a fall in macroeconomicrisk, or the volatility of the aggregate economy. Empirically, we find a strong correlation between low-frequency movements in macroeconomic volatility and low-frequency movements in the stock market. To model this phenomenon, we estimate a two-state regime switching model for the volatility and mean of consumption growth, and find evidence of a shift to substantially lower consumption volatility at the beginning of the 1990s. We then use these estimates from postwar data to calibrate a rational asset pricing model with regime switches in both the mean and standard deviation of consumption growth. Plausible parameterizations of the model are found to account for a significant portion of the run-up in asset valuation ratios observed in the late 1990s.

DOI

10.1093/rfs/hhm020

Volume

21 (4)

Pages

1653-1687

Language

en

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BibTeX

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