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

Martin Lettau, Sydney Ludvigson and Jessica Wachter ()

No 10270, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: G12 (search for similar items in EconPapers)
Date: 2004-02
New Economics Papers: this item is included in nep-dge, nep-fin, nep-mac and nep-rmg
Note: AP
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (44)

Published as Lettau, Martin, Sydney C. Ludvigson, and Jessica A. Wachter. "The Declining Equity Premium: What Role Does Macroeconomic Risk Play?" Review of Financial Studies 21(4): 1653-1687, July 2008
Published as Martin Lettau & Sydney Ludvigson & Jessica Wachter, 2005. "The declining equity premium: what role does macroeconomic risk play?," Proceedings, Board of Governors of the Federal Reserve System (U.S.).

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Journal Article: The Declining Equity Premium: What Role Does Macroeconomic Risk Play? (2008)
Working Paper: The Declining Equity Premium: What Role Does Macroeconomic Risk Play? (2006)
Journal Article: The declining equity premium: what role does macroeconomic risk play? (2005)
Working Paper: The Declining Equity Premium: What Role Does Macroeconomic Risk Play? (2004)
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