THE TIME-VARYING EQUITY PREMIUM AND THE S&P 500 IN THE TWENTIETH CENTURY

Abstract

I present a new hindcast stock market index for the United States over the twentieth century. This is constructed by calibrating a rational asset pricing model that allows for a time-varying equity premium driven by heteroskedasticity in consumption growth. By incorporating this variation in risk, the mean square error of the generated index series, when compared to the observed levels of the S&P 500, is significantly reduced. The model also explains the broad magnitudes and timings of the major bull and bear markets of the twentieth century, particularly before 1973, and the excess volatility puzzle is largely resolved.