Working Paper: NBER ID: w10270
Authors: Martin Lettau; Sydney C. Ludvigson; Jessica A. Wachter
Abstract: 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.
Keywords: Equity Premium; Macroeconomic Risk; Asset Pricing
JEL Codes: G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Reduction in macroeconomic risk (E69) | Increase in stock market valuations (G19) |
| Reduction in macroeconomic risk (E69) | Lower equity premium (G19) |
| Lower equity premium (G19) | Higher price-dividend ratio (G35) |
| Estimated posterior probabilities of being in a low volatility state (C58) | Variation in log price-dividend ratio (G19) |
| Reduction in consumption volatility (D11) | Lower equity premium (G19) |
| Reduction in consumption volatility (D11) | Higher price-dividend ratio (G35) |