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

49 Pages Posted: 9 Jun 2006  

Martin Lettau

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

Jessica A. Wachter

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

Sydney C. Ludvigson

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

Multiple version iconThere are 5 versions of this paper

Date Written: March 2006

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 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

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

Martin Lettau (Contact Author)

University of California - Haas School of Business ( email )

Haas School of Business
545 Student Services Building
Berkeley, CA 94720
United States
5106436349 (Phone)

HOME PAGE: http://faculty.haas.berkeley.edu/lettau/

Centre for Economic Policy Research (CEPR)

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London, EC1V 3PZ
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National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
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Jessica A. Wachter

University of Pennsylvania - Finance Department ( email )

The Wharton School
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Philadelphia, PA 19104
United States
215-898-7634 (Phone)
215-898-6200 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Sydney C. Ludvigson

New York University - Department of Economics ( email )

19 West 4th Street, 6th floor
New York, NY 10012
United States
212-998-8927 (Phone)
212-995-4186 (Fax)

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

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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