RFS Advance Access published online on April 12, 2007
Review of Financial Studies, doi:10.1093/rfs/hhm020
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The Declining Equity Premium: What Role Does Macroeconomic Risk Play?*
NYU, CEPR, NBER
NYU and NBER
Wharton and NBER
mlettau{at}stern.nyu.edu
sydney.ludvigson{at}nyu.edu
jwachter{at}wharton.upenn.edu
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. JEL: G12
* Lettau: Department of Finance, Stern School of Business, New York University, 44 West Fourth Street, New York, NY 10012-1126; Tel: (212) 998-0378; http://www.stern.nyu.edu/
mlettau. Ludvigson: Department of Economics, New York University, 269 Mercer Street, 7th Floor, New York, NY 10003; Tel: (212) 998-8927; http://www.econ.nyu.edu/user/ludvigsons/. Wachter: The Wharton School, University of Pennsylvania, 3620 Locust Walk, Philadelphia, PA 19104; Tel: (215) 898-7634; http://finance.wharton.upenn.edu/jwachter/. Ludvigson acknowledges financial support from the Alfred P. Sloan Foundation, and the C.V. Starr Center at NYU. We thank Ravi Bansal, Jacob Boudoukh, John Campbell, Sean Campbell, John Cochrane, Diego Comin, George Constantinides, Darrel Duffie, Robert Engle, Raquel Fernandez, Mark Gertler, Robert Hall, Lars Peter Hansen, John Heaton, Timothy Johnson, Pat Kehoe, Anthony Lynch, Ellen McGrattan, Stijn van Nieuwerburgh, Lubos Pastor, B. Ravikumar, Tom Sargent, Matthew Spiegel, Karl Walentin, Robert Whitelaw, two anonymous referees, and seminar participants at the 2003 CIREQ-CIRANO-MITACS Conference on Macroeconomics and Finance, the NBER Economic Fluctuations and Growth fall 2003 meeting, the 2004 SED annual meeting, the July 2005 FRB conference on Financial Market Risk-Premiums, the Bank of England, the Federal Reserve Bank of St. Louis, NYU, London Business School, Princeton, SUNY Stony Brook, the University of Illinois, and Wharton for helpful comments. Any errors or omissions are the responsibility of the authors.
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