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

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Author Info
Lettau, Martin
Ludvigson, Sydney
Wachter, Jessica

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Abstract

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 macroeconomic risk, 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 post-war 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.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 5519.

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Date of creation: Mar 2006
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Handle: RePEc:cpr:ceprdp:5519

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Related research
Keywords: equity premium; macroeconomic volatility; regime shifts; stock market boom;

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Find related papers by JEL classification:
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Fama, Eugene F. & French, Kenneth R., 2001. "Disappearing dividends: changing firm characteristics or lower propensity to pay?," Journal of Financial Economics, Elsevier, vol. 60(1), pages 3-43, April. [Downloadable!] (restricted)
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  2. John Heaton & Deborah Lucas, 2000. "Stock prices and fundamentals," Proceedings, Federal Reserve Bank of San Francisco, issue Apr. [Downloadable!]
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  3. Martin Lettau & Sydney C. Ludvigson, 2004. "Understanding Trend and Cycle in Asset Values: Reevaluating the Wealth Effect on Consumption," American Economic Review, American Economic Association, vol. 94(1), pages 276-299, March. [Downloadable!]
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  4. Lettau, Martin & Ludvigson, Sydney, 2002. "Expected Returns and Expected Dividend Growth," CEPR Discussion Papers 3507, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  5. John Y. Campbell, 1991. "A Variance Decomposition for Stock Returns," NBER Working Papers 3246, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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