Working Paper: CEPR ID: DP3105
Authors: Martin Lettau; Sydney Ludvigson
Abstract: Are excess stock market returns predictable over time and, if so, at what horizons and with which economic indicators? Can stock return predictability be explained by changes in stock market volatility? How does the mean return per unit risk change over time? This chapter reviews what is known about the time-series evolution of the risk-return tradeoff for stock market investment, and presents some new empirical evidence using a proxy for the log consumption-aggregate wealth ratio as a predictor of both the mean and volatility of excess stock market returns. We characterize the risk-return tradeoff as the conditional expected excess return on a broad stock market index divided by its conditional standard deviation, a quantity commonly known as the Sharpe ratio. Our own investigation suggests that variation in the equity risk-premium is strongly negatively linked to variation in market volatility, at odds with leading asset pricing models. Since the conditional volatility and conditional mean move in opposite directions, the degree of countercyclicality in the Sharpe ratio that we document here is far more dramatic than that produced by existing equilibrium models of financial market behaviour, which completely miss the sheer magnitude of variation in the price of stock market risk.
Keywords: Consumption; Expected Returns; Sharpe Ratio; Volatility
JEL Codes: G10; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| excess stock market returns (G12) | predictability over time (C41) |
| changes in stock market volatility (G17) | predictability of excess stock market returns (G17) |
| market volatility (G17) | equity risk premium (G12) |
| conditional expected excess return and conditional standard deviation (C29) | Sharpe ratio (G11) |
| conditional mean excess return and conditional volatility (C22) | opposite directions (Y80) |
| time variation in consumption volatility (D11) | predictability of excess stock returns (G17) |