The Long-Run Risks Model and Aggregate Asset Prices: An Empirical Assessment

The long-run risks model of asset prices explains stock price variation as a response to persistent ‡uctuations in the mean and volatility of consumption growth, by a representative agent with a high elasticity of intertemporal substitution. This paper documents that the model fails to …t aggregate asset prices in several important ways. The model implies that long-run consumption growth should be highly predictable from stock prices, but this is not the case. The relation between stock prices and future consumption growth is much weaker, both absolutely and relative to the relation between stock prices and lagged consumption growth, than the model implies. The relation between stock prices and consumption volatility is qualitatively consistent with the model, but quantitatively much too strong. The model cannot explain why movements in real interest rates do not generate strong predictable movements in consumption growth. Finally, the model implies extremely low yields and negative term premia on in‡ation-indexed bonds.