02572cam a22003137 4500001000700000003000500007005001700012006001900029007001500048008004100063100002000104245013400124260006600258300005700324490004200381500001900423520126800442530006001710538007201770538003601842588002501878690011201903700002502015700002402040710004202064830007702106856003802183856003702221w10270NBER20200605132519.0m o d cr cnu||||||||200605s2004 mau fo 000 0 eng d1 aLettau, Martin.14aThe Declining Equity Premium:bWhat Role Does Macroeconomic Risk Play? /cMartin Lettau, Sydney C. Ludvigson, Jessica A. Wachter. aCambridge, Mass.bNational Bureau of Economic Researchc2004. a1 online resource:billustrations (black and white);1 aNBER working paper seriesvno. w10270 aFebruary 2004.3 aAggregate 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. aHardcopy version available to institutional subscribers aSystem requirements: Adobe [Acrobat] Reader required for PDF files. aMode of access: World Wide Web.0 aPrint version record 7aG12 - Asset Pricing • Trading Volume • Bond Interest Rates2Journal of Economic Literature class.1 aLudvigson, Sydney C.1 aWachter, Jessica A.2 aNational Bureau of Economic Research. 0aWorking Paper Series (National Bureau of Economic Research)vno. w10270.40uhttp://www.nber.org/papers/w1027040uhttp://dx.doi.org/10.3386/w10270