Rare Preference Fluctuations: A Missing Piece of Multiple Asset Pricing Puzzles?

Abstract

We demonstrate that uncertainty about future preferences is of first-order importance for understanding the history of aggregate asset prices. Our analysis shows that rare and temporary fluctuations in the elasticity of intertemporal substitution and risk aversion can quantitatively account for a large array of otherwise puzzling aggregate asset pricing features despite simple aggregate consumption behavior. Such features include: equity return and risk-free rate means, volatilities, and autocorrelations; predictability (and non-predictability) relationships among price-dividend ratios, excess returns, and consumption or dividend growth; counter-cyclicality of dividend yields, risk premia, excess return volatilities, and Sharpe ratios; and an upward-sloping real yield curve.