Movements in the Equity Premium: Evidence from a Time-Varying VAR

Abstract

Previous literature has recognized the importance of regime changes in the calculation of ex-ante equity premia. However, the methodologies used to esti- mate equity premia only allow for very restrictive forms of regime transitions. This paper addresses the issue by postulating an evolving model for the law of motion of dividend growth, consumption growth and dividend-price ratio. Model parameters are then used to compute conditional and unconditional U.S. equity premia. We substan- tially extend and confirm previous work on the declining equity premium and perform exploratory data analysis in search of clues about macroeconomic factors driving the equity premium. We find that the equity premium has declined, particularly from 1950 to 1971 and from 1988 to 2000, and this decline suggests that high post-war equity returns represent the end of a high equity premium. Our results point to changing consumption volatility as an important priced factor. We find that volatility of con- sumption growth is a good indicator of economic uncertainty, and as such, its changes are reflected in expected returns, and are priced by the market.