THEJOURNALOFFINANCE?,
,althoughbynomeanstheonlyone,“EquityPre-miumPuzzle”byMehraandPrescott~1985!,,whichFederalReserveChairmanAlanGreenspandecriedas“IrrationalExuberance”evenbeforetheunprecedentedfurtherincreaseinstockpricesandprice– years,,,Idrawasharpdistinctionbetweenconditional,-termforecastsofthereturnandpre-miumdonotlessentheburdenoneconomictheorytoexplainthelargeun-conditionalmeanequityreturnandpremium,,Iarguethateventhoughonemayintroduceone’sownstrongpriorbeliefsandadjustdownwardsthesample-averageestimateofthepremium,,,thelong-termbondreturn,andtheobservedreturnsofvarioussubclassesoffinancialassetsaretoolarge,toovariable,,Irevisitandexaminetheextenttowhichwecanexplaintheassetreturnsbyrelaxingtheassumptionsofcompletecon-sumptioninsurance,perfectmarkets,—andIoffermyapologies—,Ishowthatidiosyncraticincomeshocksconcentratedinperiodsofeconomicrecessionplayakeyroleingeneratingthemeanequitypremium,thelowrisk-freerate,
,’,theirrelevanceoftheconstructofpercapitaconsumption,andthedemandforshort-termbondsbyconsumerswithmoderateriskaversion,,-tionVI,,
1570TheJournalofFinanceTableITheEquityReturnandPremiumThistableshowsthesamplemeanandstandarddeviationoftheannualizedrealarithmeticreturnontheS&PCompositeIndextotalreturnseries,thesamplemeanoftherealrisk-freerate, ~P D P!0P,wherePistherealt 1t 1t 1tttpriceoftheaggregateequityatthebeginningofyeartandDistheaggregaterealdividendt ,~1000T!$ln~P0X! T 1T 1ln~P0X!%,oftheprice0Xratio,whereXisthedividends,earnings,bookequity,-1926S&PIndexpriceseries,theCPIseries,theearningsseries,andthedividendsseriesareobtainedfromShiller’&,thereturnsarecalculatedfromtheS&P500Indexanddividendseries,,Fama,andFrench~2000!andVuolteenaho~2000!.-freerateseriesistheoneconstructedbyMehraandPrescott~2002!–20001872–19501951–20001926–2000SamplemeanS& ,,basedonevidencethatprice–dividendandprice–earningsratiosfore-castaggregateequityreturnsandthatthevaluesoftheseratiosprevailingatthebeginningofthe21stcenturyarewellabovetheirhistoricaverages,CampbellandShiller~1998!andShiller~2000!,ClausandThomas~2001!1Shiller~1984!,CampbellandShiller~1988a,1988b!,andFamaandFrench~1988!provideearlyevidencethattheaggregateprice–dividendandprice–~1999!-graphsandinAppendixA,Iarguethattheforecastabilityresultsprovidelittle,ifany,guidancetomyprimarygoalinthissection,theestimationoftheunconditionalmeanequityreturn.
RationalAssetPrices1571calculatetheexpectedaggregateequitypremiumtobealittleabove3per-centintheperiod1985to1998,basedonanalysts’,Welch~2001!,,thecurrentlylowconditional,,–dividendandprice–earningsratiosraisesthepossibilitythatuseofthesefinancialratiosmayimproveupontheestimatesoftheunconditionalmeanequityreturn~andpremium!thatarebasedonthesamplemean,anapproachpursued2earlierbyFamaandFrench~2002!.Overtheperiod1872to2000,theprice––,theprice––-meanestimateoftheunconditionalmeanreturnonequity,,,,elec-tronictrading,thegrowthofmutualfunds,thegrowthofdefined-contributionpensionplans,“neweconomy”-mateoftheunconditionalmeanreturnandpremium?Toaddressthisissue,Idenotebyy[ln~P0X!thelogarithmoftheratioofthepricetothettt2TheestimatorsemployedinFamaandFrench~2002!–~1999!,Shiller~2000!,andMcGrattanandPrescott~2001!providelucidaccountsofanumberoftheseexplanationsinthecontextofbothrationaleconomicmodelsandmodelsthatdeviatefromfullrationality.
1572TheJournalofFinancenormalizingvariableX,wherethenormalizingvariablestandsfortheaggre-tgatedividends,earnings,bookequity,NationalIncome,,themeanannual~geometric!growthofthefinancialratioP0Xisgivenby~y y! 11estimatoroftheunconditionalmeanoftheannualaggregaterealequityreturnasthesamplemeanreturn,lesssomefractionbetaofthesamplemeanZannualgrowthofthefinancialratio,R b~y y! 11equityreturnandthelogfinancialratioarestationaryprocesses,,~meansquarederror!adjustedestimatorisequaltotheslopecoefficientoftheregressionofthesamplemeanreturnonthesamplemeangrowthofthefinancialratio,~y y! 11onlyonesample~oflengthT!,,Ipresentasetofsufficientconditionsthatimplythatthebetaofthemostefficientestimatorwithinthisclassofad-justedestimatorsisequaltoone,whentheadjustmentisbasedontheprice–,theothermainconditionsarethattheprice–dividendratiodoesnotforecastthelong-rungrowthindividendsandthelong-rundividendgrowthdoesnotforecasttheprice–~non!,,themeanannualgrowthoftheprice–,theprice–,theprice–,andtheprice––earningsratiofromthesamplemean,,themeanannualgrowthoftheprice–dividendratioandprice–,,-tially,thechangeinthefinancialratiosis“amortized”,~1998!.6Acaveatisinorder:Withoutadditionalassumptions,itisunclearwhatoptimalityprop-erties~beyondunbiasedness!,normaximumlikelihood,norBayesianmethodsmotivatethisclassofestimatorswithoutfur-therassumptions.
-expectationseconomicmodelparsimoniouslylinksthereturnsofallassetstothepercapitaconsumptiongrowththroughtheEulerequationsofconsumption~seeMerton~1973!,Rubinstein~1976!,Lucas~1978!,andBreeden~1979!!.Accordingtothetheory,,percapitaconsumptiongrowthcovariestoolittlewiththereturnsofmostclassesoffinancialassetsandthiscreatesawholeclassofasset-pricingpuzzles:theaggregateequityreturn,thelong-termbondre-turn,andthereturnsofvarioussubclassesoffinancialassetsaretoolarge,toovariable,,,,,,,,thestrategyofincreasingtheriskaversioncoeffi-cientinordertolevertheeffectoftheproblematiclowcovarianceofcon-sumptiongrowthwithequityreturnsincreasesthepredictedrisk-freerate7GrossmanandShiller~1981!,HansenandSingleton~1982!,FersonandConstantinides~1991!,HansenandJagannathan~1991!,~1985!-gregateequityreturnovertherisk-freerateis,atmost,,~1989!stressesthatthepuzzleisadualpuzzleoftheobservedtoohighequityreturnandtoolowrisk-freerate.
,-8tionsonpreferences,modifiedprobabilitydistributionstoadmitrarebut910disastrousmarket-wideevents,incompletemarkets,,temporalaggre-1314gation,,Lo,andMacKinlay~1997!andCochrane~2001!,andinthearticlesbyCochraneandHansen~1992!,Kocherlakota~1996!,Cochrane~1997!,Campbell~2001,2002!,andMehraandPrescott~2002!.,,,Ihavegrownskepticalofhowmeaningfulaneconomicconstructaggregate~asopposedtodisaggregate!consumptionis,8Forexample,Abel~1990!,Constantinides~1990!,EpsteinandZin~1991!,FersonandCon-stantinides~1991!,BenartziandThaler~1995!,CampbellandCochrane~1999!,Anderson,Hansen,andSargent~2000!,BansalandYaron~2000!,andBoldrin,Christiano,andFisher~2001!.9ThemeritsofthisexplanationarediscussedinMehraandPrescott~1988!andRietz~1988!.10Forexample,Bewley~1982!,MehraandPrescott~1985!,Mankiw~1986!,ConstantinidesandDuffie~1996!,HeatonandLucas~1996!,Storesletten,Telmer,andYaron~2001!,Brav,Con-stantinides,andGeczy~2002!,andKrebs~2002!.11Forexample,AiyagariandGertler~1991!,Danthine,Donaldson,andMehra~1992!,HeandModest~1995!,BansalandColeman~1996!,HeatonandLucas~1996!,DanielandMarshall~1997!,andConstantinides,Donaldson,andMehra~2002a!.12MankiwandZeldes~1991!,BravandGeczy~1995!,Attanasio,Banks,andTanner~2002!,Bravetal.~2002!,andVissing-Jorgensen~2002!.13Heaton~1995!,Lynch~1996!,andGabaixandLaibson~2001!.14SeeBrown,Goetzmann,andRoss~1995!.However,JorionandGoetzmann~1999,Table6!.
,-pletemarket,heterogeneoushouseholdsareabletoequalize,statebystate,-household,full-informationeconomyisisomorphicinitspricingimplicationstotheequilibriuminarepresentative-household,full-informationeconomy,16ifhouseholdshavevonNeumann–~1982!,MehraandPrescott~1985!,andMankiw~1986!suggestthepotentialofenrichingtheasset-pricingimplicationsoftherepresentative-17householdparadigm,-stantinidesandDuffie~1996!,byconstruction,theexistenceofhouse-holdincomeprocesses,consistentwithgivenaggregateincomeanddividendprocesses,,,thenthehouse-holdconsumptiongrowthisequal,statebystate,totheaggregateconsump-tiongrowth,,,,theincomeshocksmustbeheteroscedastic,,~1960!,Constantinides~1982!,andMehraandPrescott~1985,anunpublishedearlierdraft!.~1991!,Mace~1991!,Altonji,Hayashi,andKotlikoff~1992!,andAttanasioandDavis~1997!.18AiyagariandGertler~1991!andHeatonandLucas~1996!findthatconsumersfacingtransientshockscomeclosetothecomplete-marketsruleofcompleterisksharingevenwithtransactioncostsand0orborrowingcosts,providedthatthesupplyofbondsisnotrestrictedtoanunrealisticallylowlevel.
:Theriskpremiumishighestinare-cessionbecausethestockisapoorhedgeagainsttheuninsurableincomeshocks,suchasjobloss,-miumpuzzle:Eventhoughpercapitaconsumptiongrowthispoorlycorre-latedwithstocksreturns,investorsrequireaheftypremiumtoholdstocksovershort-termbondsbecausestocksperformpoorlyinrecessions,-tionlessmarkets,itimpliesthattheEulerequationsofhousehold~butnotnecessarilyofpercapita!,sincethegivenpriceprocesseshaveembeddedinthemwhateverpredictabilityofre-turnsbytheprice–dividendratios,dividendgrowthrates,andotherinstru-mentsthattheresearchercarestoascribetoreturns,.~2002!-miumofthevalue-weightedandtheequallyweightedmarketportfoliore-turnovertherisk-freerate,,~1996!,~1996!modeltheincomeprocessasunivariateandprovideempiricalevidencefromthePanelStudyonIncomeDynamics~PSID!.~2001!,Telmer,andYaron~2000!,Jacobs~1999!studiesthePSIDdatabaseonfoodconsumption;Cogley~2002!andVissing-Jorgensen~2002!studytheCEXdatabaseonbroadmeasuresofconsump-tion;JacobsandWang~2001!studytheCEXdatabasebyconstructingsyntheticcohorts;andAit-Sahalia,Parker,andYogo~2001!instrumentthehouseholdconsumptionwiththepurchasesofcertainluxurygoods.
.~2002!findthat,inadditiontothemeanandvariance,~2002!providesatheoreticaljustificationastowhyitispossiblethatneitherthevariancenortheskewness,~1996!,,KrebsdemonstratesthattheoriginalpropositionofCon-stantinidesandDuffieremainsvalid,thatis,thereexisthouseholdincomeprocesses,consistentwithgivenaggregateincomeanddividendprocesses,,,IpresentanexamplebasedonKrebs~2002!.-tinidesetal.~2002a!,aperiodofhumancapitalacquisition,,,-rivedfromtheirwagesforthcomingintheirmiddleage,,,theyareunwillingtodecreasetheircurrentconsump-tioninordertosavebyinvestinginequity,,buttheborrowingconstraintpreventsthemfromdoing
,,inadditiontothedemandforequity,,atleastinpart,theequitypremium,thelimitedparticipationinthestockmarket,.~2001!,andConstantinides,Donaldson,andMehra~2001!.~2001!~1999!—AnOldFolks’TaleThelowcovarianceofthegrowthrateofaggregateconsumptionwithequityreturnsisamajorstumblingblockinexplainingthemeanaggregateequitypremiumandthecrosssectionoftheassetreturns,~1986!,anumberofdifferenteconomicmodelshavebeenproposedthateffectivelyincreasethecovarianceofequityreturnswiththegrowthrateofaggregateconsumption,’tale,introducedinConstantinides,Donaldson,andMehra~2002a,2002b!,thataccomplishesthisgoalwithoutintroducingEpstein–Zin~1991!,Merton,andSamuelson~1992!,JagannathanandKocherlakota~1996!,BertautandHaliassos~1997!,Cocco,Gomes,andMaen-hout~1999!,andStoreslettenetal.~2001!.22FriendandBlume~1975!~1991!,~1996!introduceasetofpreferencesdefinedoverconsumptionandwealth—thespiritofcapitalism—thatalsohavetheeffectofintroducingthestockmarketreturnintheEulerequationsofconsumption.
RationalAssetPrices1579Oldfolkswhoarerichenoughtobenontrivialinvestorsinthecapitalmar-ketscareabouttheirwealthjustasmuchasyoungerfolksdo,-generationseconomy,“consumption”“consumption”oftheoldconsistsoftwocomponents,directconsumption,c;Dandthe“joyofgiving,”c,’directconsumptionisconstrainedbythestateoftheirhealth,thecorrelationbetweenthedirectconsumptionoftheoldandthestockmarketreturnislow,,thebalanceoftheoldhouseholds’wealth,c,,u~c! v~c!,thatisseparableoverdirectDBconsumptionandbequests,themodelpredictsanEulerequationofconsump-''tionwithmarginalutilityattheoldagegivenbyv~c!andnotbyu~c!,,itreinforcesthegeneralpointthatpercapitaconsumptionmeasuresneitherthetotalconsumptionofthemarginalinvestorinthestockmarketnorthatpartofthemarginalinvestor’-sumptioniscountedinthemeasureofpercapitaconsumptiondonotholdstocks,ittookapaperbyMankiwandZeldes~1991!-tionheldstockeitherdirectlyorindirectlyin1998,comparedto36percentin1989,,,severalpapershavestudiedthesavingsandportfoliocompositionofhouse-holds,stratifiedbyincome,wealth,age,education,~1993!,HaliassosandBertaut~1995!,HeatonandLucas~1999,2000!,Poterba~2001!,andthecollectedessaysinGuiso,Haliassos,andJappelli~2001!.
1580TheJournalofFinanceMankiwandZeldes~1991!calculatethepercapitafoodconsumptionofasubsetofhouseholds,~1995!confirmtheirresultbyusingthenondurablesandservicespercapitaconsumption,reconstructedfromtheConsumerExpenditureSurvey~CEX!.~2002!,Bravetal.~2002!,andVissing-Jorgensen~2002!findsomeevidencethatpercapitaconsumptiongrowthcanexplaintheequitypremiumwitharelativelyhighvalueoftheRRAcoefficient,,,,,datingbacktoMarshall~1920!andDuesenberry~1949!.~1973!andSun-daresan~1989!,IdemonstrateinConstantinides~1990!thathabitpersis-tencecan,inprinciple,-temporalelasticityofsubstitutioninconsumption,,,giventheriskaver-sion,~1970!~1990!andCampbellandCochrane~1999!address24FersonandConstantinides~1991!~1991!andHeaton~1995!.
,thelatterintroduceanonlinearspecificationofhabit,,thepredictabilityoflong-horizonreturns,-sumption,themodelhitstheaggregateprice–~NIPA!percapitaconsumptionseriesisanimperfectproxyoftheconsump-tionofinvestorsthataremarginalinthecapitalmarkets,giventheearlier-identifiedproblemsofincompleteconsumptioninsurance,limitedparticipationofhouseholdsinthecapitalmarkets,borrowingconstraints,,,includingtheconsumption––~1992!~2001!reportsthatlonglagsofconsumptiongrowthpredicttheshort-terminterestrate,~2001!reportsthatinboththelinearandthenonlinearexternalhabitmodels,,Santos,andVeronesi~2001!developanexternalhabitmodelandreportthatithelpsexplainthecrosssectionofassetreturns.
,Iarguethatwegoalongwaytowardaddressingmarketbehaviorbyrecognizingthatconsumersfaceuninsurableandidiosyncraticincomeshocks,forexample,,however,,thedemandforbonds—Whoholdsbondsiftheequitypremiumissohigh?—,Iarguethatrelaxingtheassumptionofconveniencethatprefer-encesaretimeseparabledrivesawedgebetweenthepreferencepropertiesofriskaversionandintertemporalelasticityofsubstitution,withintheclassofvonNeumann–,thelifecycle,borrowingconstraints,,Ibelievethatspecificdeviationsfromrationalityintheagents’choicesandintheagents’,severalexamplesofapparentdeviationfromrationalitymaybereconciledwiththerationaleconomicparadigm,,~1936!wroteaboutanimalspirits,and15sinceShiller~1984!wroteaboutnoisetradersandDeBondtandThaler~1985!-26BarberisandThaler~2002!andHirshleifer~2001!~2002!provideexcellentdiscussionoftheseissues.
, 1 1 1RZ[TR bT~y y! RZ bT~y y!.~A1!x(t 1T 11SAMPLET 11t 1Thetermy[ln~P0X!isthelogarithmofthepriceofaggregateequity,tttnormalizedwiththevariableX,whereXstandsfortheaggregatedivi-ttdends,earnings,bookequity,NationalIncome,@y y# 0ttT 1Zvar~R! var~RZZ! 2bcov~R,T~y y!!xSAMPLESAMPLET 11~A2!2 1 bvar~T~y y!!T 11andisminimizedwhenbetaissetequalto 1RZcov~,T~y y!!SAMPLET 11*b .~A3! 1var~T~y y!!T 11Thebetaofthemostefficient~meansquarederror!estimatorisequalto 1ZtheslopecoefficientoftheregressionofRonT~y y!.SAMPLET 11SinceIhaveonlyonesampleoflengthT,,withinthesampleoflengthT,Icanexaminethehigh-frequencybehaviorofthejointtimeseriesRandy,,considerthecaseinwhichystandsforthelogprice––dividendratioforecastsin-samplelowlong-horizonreturns,itisaplausiblepriorbeliefthatitalsoforecastslowT-horizonreturns,cov~RZ,y! 0,forT 50years~1951to2000!orSAMPLE1
1584TheJournalofFinanceT 129years~1872to2000!.Itisalsoaplausiblepriorbeliefthatperiodsofhighreturnsarenotfollowedbylowprice–dividendratios,thatis,itisZplausibletobelievethatcov~R,y! ~A3!impliesSAMPLET ~butnotnecessary!–dividendratioandassumethefollowing:~1!there-turnsandtheprice–dividendratioarestationary,~2!theprice–dividendra-tiodoesnotforecastthegrowthindividends,~3!dividendgrowthdoesnotforecasttheprice–dividendratio,~4!theprice–dividendratiodoesnotfore-castthedifferenceintheconditionalvarianceofthecapitalgainrateandthedividendgrowthrate,and~5!thedifferenceintheconditionalvarianceofthecapitalgainrateandthedividendgrowthratedoesnotforecasttheprice–,IuseaTaylor-seriesexpansion: y P0P D0D k~A4!t 1t 1tt 1tt 1where22k[~ P0P!02 ~ D0D!02t 1t 1tt 1tandwritethesamplemeanofthearithmeticreturnasT 1RZ[T$D0P P0P%SAMPLE(t 1tt 1tt 1T 1~A5! T$D0P D0D k y%(t 1tt 1tt 1t 1t 1T 1 1 T$D0P D0D k% T~y y!.(t 1tt 1tt 1T 11t 1ZIsubstitutethevalueofRfromequation~A5!intoequation~A3!andSAMPLEobtaintheresultthatthevarianceoftheestimatorisminimizedwhenthevalueofbetaisone:TTcovD0P,~y y!cov D0D,y(t 1tT 11(t 1tT 1 t 1t 1*b var~y y!var~y y!T 11T 11TT~A6!cov D0D,ycovk,~y y!(t 1t1(t 1T 11 t 1t 1 1var~y y!var~y y!T 11T 11 1.
RationalAssetPrices1585Thefirstterminequation~A6!isapproximatelyzerobecausethestation-arityoftheprice–dividendratioimpliesTTcovD0P,y covD0P,y.~A7!(t 1tT 1(t 1t1 t 1t 1Thesecondterminequation~A6!iszerobecause,byassumption,thedividendgrowthratedoesnotforecasttheprice–,byassumption,theprice–,thefourthtermiszerobecause,byassumption,theprice–,whenXstandsforthedividendsandconditions~1!–~5!hold,thetminimumvarianceestimatorintheclassofestimatorsgivenbyequation~A1!is 1RZ RZ T~y y!DSAMPLET 11~A8!TT 1 1 T$D0P D0D% Tk.(t 1tt 1t(t 1t 1t 1FamaandFrench~2002!reportadjustedestimatesoftheunconditionalmeanreturn~andpremium!,theirestimateoftheexpectedstockreturnbasedonthedividend T1growthmodelisequivalenttoT$D0P D0D%andtheir(t 1t 1tt 1t T1biased-adjustedestimateisequivalenttoT$D0P D0D% (t 1t 1tt 1t ~2001!alsoreportadjustedestimatesof(t 1t 1theunconditionalmeanreturn~andpremium!basedondividends,income,earnings,payoutratio,bookequity,(1996)ModelIillustrateanextensionoftheConstantinidesandDuffie~1996!modelalongthelinesofKrebs~2002!.’sconsumption,c,followstheprocessi,tccitt Xh.~B1!i,ti,tcci,t 1t 1
1586TheJournalofFinanceTherandomvariables$h%havethefollowingproperties:Distinctsubsetsi,tof$h%areindependent;foralliandt;hisindependentofc,c,c,X,i,ti,tt 1ti,t 1i,tandtheassetprices;andE@h# $h%arei,ti,tindependentoftheassetprices,,~1996!model,theidiosyncraticincome2be b02ti,tshocksarelognormal:X ewithenormalandh[,ti,ti,t2conditionalvariance,b,. I1 a~2002!findthatthepricingkernelI~c0c!goesalongway(i 1i,ti,t 1towardexplainingtheequitypremiumandthevalue-versus-growthpre-2mium,theyalsofindlittleevidencethattheconditionalvariance,b,istcorrelatedwithstockreturns,,tIassumethattherandomvariables$X%havethefollowingproperties:itDistinctsubsetsof$X%areindependent;foralliandt,Xisindependentititofc,c,candX;andXhasthefollowingbinomialdistribution:t 1ti,t 1i,t 1it 1 1 a1 a1 yptX ,withprobability1 pi,t1 p~B2! 1 1 aa yp,withprobabilityp,twhere0,p 1,,y , ,~B3!t ccci,t 1t 1t 1argumentsalongthelinesinConstantinidesandDuffie~1996!-texpectationoftheithhousehold’smarginalrateofsubstitution,conditionalon$c0c,y%,istt 1t accitt rEe,yt cci,t 1t 1 ac 1 1t r1 a a1 a a a e$~1 p!~1 yp! y%E@h#tti,t~B4! ct 1 act r a e~1 y!E@h#,forp ,t ct 1
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