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

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Author Info
Martin Lettau
Sydney C. Ludvigson

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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. 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 show that there is a strong and statistically robust correlation between low macroeconomic volatility and high asset prices: the estimated posterior probability of being in a low volatility state explains 30 to 60 percent of the post-war variation in the log price-dividend ratio, depending on the measure of consumption analyzed. Next, we study a rational asset pricing model with regime switches in both the mean and standard deviation of consumption growth, where the probabilities of a regime change are calibrated to match estimates from post-war data. Plausible parameterizations of the model are found to account for a significant fraction of the run-up in asset valuation ratios observed in the late 1990s.

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Paper provided by Society for Economic Dynamics in its series 2004 Meeting Papers with number 644.

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Date of creation: 2004
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Handle: RePEc:red:sed004:644

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Related research
Keywords: Equity Premium; Macro Volatility;

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

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  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. 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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  3. 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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  4. John Heaton & Deborah Lucas, 2000. "Stock prices and fundamentals," Proceedings, Federal Reserve Bank of San Francisco, issue Apr. [Downloadable!]
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  5. 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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This page was last updated on 2009-11-5.

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