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
DO - 10.3386/w10270
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 -