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

A large body of research has stressed the importance of time varying risk premia in explaining asset pricing puzzles. We propose an empirical model for dividend growth, consumption growth and dividend-prices that is consistent with this literature and use it to estimate conditional and unconditional U.S. equity premia. We then explore the relationship between our equity premium measures and possible sources of macroeconomic risk. We extend and confirm previous work on the declining equity premium, and do some exploratory data analysis in search of clues about factors driving the equity premium. To estimate the ex-ante equity premium, we model dividend growth, consumption growth and dividend prices as a VAR with drifting parameters and stochastic, time-varying, variance covariance matrix, and estimate it in a Bayesian fashion by means of a Gibbs sampler. 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 factor driving the premium. We find that volatility of consumption growth is a good indicator of economic uncertainty, and as such, changes are reflected in expected returns, and are priced by the market.