DP5519 The Declining Equity Premium: What Role Does Macroeconomic Risk Play?

Author(s): Martin Lettau , Sydney Ludvigson , Jessica Wachter

Publication Date: March 2006

Keyword(s): equity premium , macroeconomic volatility , stock market boom , regime shifts

JEL(s): G12

Programme Areas: Financial Economics , International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP5519.asp

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.