TY - JOUR AU - Lettau,Martin AU - Ludvigson,Sydney C. AU - Wachter,Jessica A. TI - The Declining Equity Premium: What Role Does Macroeconomic Risk Play? JF - National Bureau of Economic Research Working Paper Series VL - No. 10270 PY - 2004 Y2 - February 2004 UR - http://www.nber.org/papers/w10270 L1 - http://www.nber.org/papers/w10270.pdf N1 - Author contact info: Martin Lettau Haas School of Business University of California, Berkeley 545 Student Services Bldg. #1900 Berkeley, CA 94720-1900 Tel: 510/642-6349 Fax: 510/643-1412 E-Mail: lettau@haas.berkeley.edu Sydney C. Ludvigson Department of Economics New York University 19 W. 4th Street, 6th Floor New York, NY 10002 Tel: 212/998-8927 Fax: 212/995-4186 E-Mail: sydney.ludvigson@nyu.edu Jessica Wachter Department of Finance 2300 SH-DH The Wharton School University of Pennsylvania 3620 Locust Walk Philadelphia, PA 19104 Tel: 215/898-7634 Fax: 215/898-6200 E-Mail: jwachter@wharton.upenn.edu AB - 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. 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 show that there is a strong and statistically robust correlation between low macroeconomic volatility and high asset prices: the estimated posterior probability of being in a low volatility state explains 30 to 60 percent of the post-war variation in the log price-dividend ratio, depending on the measure of consumption analyzed. Next, we study a rational asset pricing model with regime switches in both the mean and standard deviation of consumption growth, where the probabilities of a regime change are calibrated to match estimates from post-war data. Plausible parameterizations of the model are found to account for a significant fraction of the run-up in asset valuation ratios observed in the late 1990s. ER -