The Journal of Finance

Why Is Long‐Horizon Equity Less Risky? A Duration‐Based Explanation of the Value Premium

Published: 01/11/2007   |   DOI: 10.1111/j.1540-6261.2007.01201.x

MARTIN LETTAU, JESSICA A. WACHTER

We propose a dynamic risk‐based model that captures the value premium. Firms are modeled as long‐lived assets distinguished by the timing of cash flows. The stochastic discount factor is specified so that shocks to aggregate dividends are priced, but shocks to the discount rate are not. The model implies that growth firms covary more with the discount rate than do value firms, which covary more with cash flows. When calibrated to explain aggregate stock market behavior, the model accounts for the observed value premium, the high Sharpe ratios on value firms, and the poor performance of the CAPM.

Consumption, Aggregate Wealth, and Expected Stock Returns

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00347

Martin Lettau, Sydney Ludvigson

This paper studies the role of fluctuations in the aggregate consumption–wealth ratio for predicting stock returns. Using U.S. quarterly stock market data, we find that these fluctuations in the consumption–wealth ratio are strong predictors of both real stock returns and excess returns over a Treasury bill rate. We also find that this variable is a better forecaster of future returns at short and intermediate horizons than is the dividend yield, the dividend payout ratio, and several other popular forecasting variables. Why should the consumption–wealth ratio forecast asset returns? We show that a wide class of optimal models of consumer behavior imply that the log consumption–aggregate wealth (human capital plus asset holdings) ratio summarizes expected returns on aggregate wealth, or the market portfolio. Although this ratio is not observable, we provide assumptions under which its important predictive components for future asset returns may be expressed in terms of observable variables, namely in terms of consumption, asset holdings and labor income. The framework implies that these variables are cointegrated, and that deviations from this shared trend summarize agents' expectations of future returns on the market portfolio.

Capital Share Risk in U.S. Asset Pricing

Published: 03/30/2019   |   DOI: 10.1111/jofi.12772

MARTIN LETTAU, SYDNEY C. LUDVIGSON, SAI MA

A single macroeconomic factor based on growth in the capital share of aggregate income exhibits significant explanatory power for expected returns across a range of equity characteristic portfolios and nonequity asset classes, with risk price estimates that are of the same sign and similar in magnitude. Positive exposure to capital share risk earns a positive risk premium, commensurate with recent asset pricing models in which redistributive shocks shift the share of income between the wealthy, who finance consumption primarily out of asset ownership, and workers, who finance consumption primarily out of wages and salaries.

Monetary Policy and Asset Valuation

Published: 01/19/2022   |   DOI: 10.1111/jofi.13107

FRANCESCO BIANCHI, MARTIN LETTAU, SYDNEY C. LUDVIGSON

We document large, longer term, joint regime shifts in asset valuations and the real federal funds rate‐r*$r^{\ast }$ spread. To interpret these findings, we estimate a novel macrofinance model of monetary transmission and find that the documented regimes coincide with shifts in the parameters of a policy rule, with long‐term consequences for the real interest rate. Estimates imply that two‐thirds of the decline in the real interest rate since the early 1980s is attributable to regime changes in monetary policy. The model explains how infrequent changes in the stance of monetary policy can generate persistent changes in asset valuations and the equity premium.

Have Individual Stocks Become More Volatile? An Empirical Exploration of Idiosyncratic Risk

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00318

John Y. Campbell, Martin Lettau, Burton G. Malkiel, Yexiao Xu

This paper uses a disaggregated approach to study the volatility of common stocks at the market, industry, and firm levels. Over the period from 1962 to 1997 there has been a noticeable increase in firm‐level volatility relative to market volatility. Accordingly, correlations among individual stocks and the explanatory power of the market model for a typical stock have declined, whereas the number of stocks needed to achieve a given level of diversification has increased. All the volatility measures move together countercyclically and help to predict GDP growth. Market volatility tends to lead the other volatility series. Factors that may be responsible for these findings are suggested.