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

Posted: 8 Aug 2008

See all articles by Martin Lettau

Martin Lettau

University of California - Haas School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Sydney C. Ludvigson

New York University - Department of Economics; National Bureau of Economic Research (NBER)

Jessica A. Wachter

University of Pennsylvania - Finance Department; National Bureau of Economic Research (NBER)

Multiple version iconThere are 5 versions of this paper

Date Written: July 2008

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 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.

Keywords: G12

Suggested Citation

Lettau, Martin and Ludvigson, Sydney C. and Wachter, Jessica A., The Declining Equity Premium: What Role Does Macroeconomic Risk Play? (July 2008). The Review of Financial Studies, Vol. 21, Issue 4, pp. 1653-1687, 2008. Available at SSRN: https://ssrn.com/abstract=1212063 or http://dx.doi.org/10.1093/rfs/hhm020

Martin Lettau (Contact Author)

University of California - Haas School of Business ( email )

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Sydney C. Ludvigson

New York University - Department of Economics ( email )

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HOME PAGE: http://www.econ.nyu.edu/user/ludvigsons/

National Bureau of Economic Research (NBER)

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Jessica A. Wachter

University of Pennsylvania - Finance Department ( email )

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215-898-6200 (Fax)

National Bureau of Economic Research (NBER)

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