Working Paper: CEPR ID: DP3103
Authors: Martin Lettau; Sydney Ludvigson
Abstract: Evidence suggests that expected excess stock market returns vary over time, and that this variation is much larger than that of expected real interest rates. It follows that a large fraction of the movement in the cost of capital in standard investment models must be attributable to movements in equity risk premia. In this Paper we emphasise that such movements in equity risk premia should have implications not merely for investment today, but also for future investment over long horizons. In this case, predictive variables for excess stock returns over long-horizons are also likely to forecast long-horizon fluctuations in the growth of marginal Q, and therefore investment. We test this implication directly by performing long-horizon forecasting regressions of aggregate investment growth using a variety of predictive variables shown elsewhere to have forecasting power for excess stock market returns.
Keywords: investment; q-theory; risk premia
JEL Codes: E22; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Decline in equity risk premium (G12) | Increase in stock prices (G10) |
| Increase in stock prices (G10) | Reduce cost of capital (G32) |
| Reduce cost of capital (G32) | Increase current investment (E22) |
| Decline in equity risk premium (G12) | Increase current investment (E22) |
| Decline in equity risk premium (G12) | Lower expected future stock returns (G17) |
| Lower expected future stock returns (G17) | Negative covariance between current stock returns and future investment growth (G17) |
| Log consumption-aggregate wealth ratio (E25) | Forecast long-horizon investment growth (E27) |
| Log consumption-aggregate wealth ratio (E25) | Lower equity risk premia (G12) |
| Lower equity risk premia (G12) | Slower future investment growth (D25) |