49 Pages Posted: 9 Jun 2006
Date Written: March 2006
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.
Keywords: Equity premium, macroeconomic volatility, stock market boom, regime shifts
JEL Classification: G12
Suggested Citation: Suggested Citation
Lettau, Martin and Wachter, Jessica A. and Ludvigson, Sydney C., The Declining Equity Premium: What Role Does Macroeconomic Risk Play? (March 2006). CEPR Discussion Paper No. 5519. Available at SSRN: https://ssrn.com/abstract=907463
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