IDEAS home Printed from
MyIDEAS: Login to save this article or follow this journal

The declining equity premium: what role does macroeconomic risk play?

  • Martin Lettau
  • Sydney Ludvigson
  • Jessica A. Wachter

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 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. The Author 2007. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email:, Oxford University Press.

(This abstract was borrowed from another version of this item.)

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL:
Download Restriction: no

Article provided by Board of Governors of the Federal Reserve System (U.S.) in its journal Proceedings.

Volume (Year): (2005)
Issue (Month): ()

in new window

Handle: RePEc:fip:fedgpr:y:2005:x:27
Contact details of provider: Postal: 20th Street and Constitution Avenue, NW, Washington, DC 20551
Web page:

More information through EDIRC

Order Information: Email:

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.:

as in new window
  1. Martin Lettau & Sydney Ludvigson, 2003. "Expected Returns and Expected Dividend Growth," NBER Working Papers 9605, National Bureau of Economic Research, Inc.
  2. Bonomo, m. & Garcia, r., 1991. "Can Well-Fitted Equilibrium Asset Pricing Model Produce Mean Reversion?," Cahiers de recherche 9127, Universite de Montreal, Departement de sciences economiques.
  3. Sydney Ludvigson, 1999. "Consumption And Credit: A Model Of Time-Varying Liquidity Constraints," The Review of Economics and Statistics, MIT Press, vol. 81(3), pages 434-447, August.
  4. Martin Lettau & Sydney Ludvigson, 2003. "Understanding Trend and Cycle in Asset Values: Reevaluating the Wealth Effect on Consumption," NBER Working Papers 9848, National Bureau of Economic Research, Inc.
  5. Annette Vissing-Jorgensen, 2002. "Limited Asset Market Participation and the Elasticity of Intertemporal Substitution," Journal of Political Economy, University of Chicago Press, vol. 110(4), pages 825-853, August.
  6. Robert B. Barsky, 1986. "Why Don't the Prices of Stocks and Bonds Move Together?," NBER Working Papers 2047, National Bureau of Economic Research, Inc.
  7. John Heaton & Deborah J. Lucas, 2000. "Stock prices and fundamentals," Proceedings, Federal Reserve Bank of San Francisco, issue Apr.
  8. Otrok, Christopher & Ravikumar, B. & Whiteman, Charles H., 2002. "Habit formation: a resolution of the equity premium puzzle?," Journal of Monetary Economics, Elsevier, vol. 49(6), pages 1261-1288, September.
  9. Orazio P. Attanasio & Guglielmo Weber, 1993. "Consumption Growth, the Interest Rate and Aggregation," Review of Economic Studies, Oxford University Press, vol. 60(3), pages 631-649.
  10. Campbell, John Y, 1991. "A Variance Decomposition for Stock Returns," Economic Journal, Royal Economic Society, vol. 101(405), pages 157-79, March.
  11. Marco Cagetti & Lars Peter Hansen & Thomas Sargent & Noah Williams, 2002. "Robustness and Pricing with Uncertain Growth," Review of Financial Studies, Society for Financial Studies, vol. 15(2), pages 363-404, March.
  12. Annette Vissing-Jorgensen, 2002. "Limited Asset Market Participation and the Elasticity of Intertemporal Substitution," NBER Working Papers 8896, National Bureau of Economic Research, Inc.
  13. Martin Lettau & Sydney C. Ludvigson & Jessica A. Wachter, 2008. "The Declining Equity Premium: What Role Does Macroeconomic Risk Play?," Review of Financial Studies, Society for Financial Studies, vol. 21(4), pages 1653-1687, July.
  14. Abel, Andrew B., 1999. "Risk premia and term premia in general equilibrium," Journal of Monetary Economics, Elsevier, vol. 43(1), pages 3-33, February.
  15. Eugene F. Fama & Kenneth R. French, 2001. "Disappearing Dividends: Changing Firm Characteristics Or Lower Propensity To Pay?," Journal of Applied Corporate Finance, Morgan Stanley, vol. 14(1), pages 67-79.
  16. Bansal, Ravi & Lundblad, Christian, 2002. "Market efficiency, asset returns, and the size of the risk premium in global equity markets," Journal of Econometrics, Elsevier, vol. 109(2), pages 195-237, August.
Full references (including those not matched with items on IDEAS)

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

When requesting a correction, please mention this item's handle: RePEc:fip:fedgpr:y:2005:x:27. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Kris Vajs)

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.