12/2/2014: The Origins of Stock Market Fluctuations

An exceptionally ambitious paper on drivers of stock markets changes over long time horizon. A must-read for my students in MSc Finance and certainly going on syllabus next year. Big paper, big conclusions.


"The Origins of Stock Market Fluctuations" by Daniel L. Greenwald, Martin Lettau, and Sydney C. Ludvigson (NBER Working Paper No. 19818, January 2014, http://www.nber.org/papers/w19818).

"Three mutually uncorrelated economic shocks that we measure empirically explain 85% of the quarterly variation in real stock market wealth since 1952."

This is an unbelievably strong statement. Traditionally, little attention is given "to understanding the real (adjusted for inflation) level of the stock market, i.e., stock price variation, or the cumulation of returns over many decades. The profession spends a lot of time debating which risk factors drive expected excess returns, but little time investigating why real stock market wealth has evolved to its current level compared to 30 years ago. To understand the latter, it is necessary to probe beyond the role of stationary risk factors and short-run expected returns, to study the primitive economic shocks from which all stock market (and risk factor) fluctuations originate."

"Stock market wealth evolves over time in response to the cumulation of both transitory expected return and permanent cash flow shocks. The crucial unanswered questions are, what are the economic sources of these shocks? And what have been their relative roles in evolution of the stock market over time?"

The authors use "a model to show that they are the observable empirical counterparts to three latent primitive shocks: a total factor productivity shock, a risk aversion shock that is unrelated to aggregate consumption and labor income, and a factors share shock that shifts the rewards of production between workers and shareholders."

And the core conclusions are: "On a quarterly basis, risk aversion shocks explain roughly 75% of variation in the log difference of stock market wealth, but the near-permanent factors share shocks plays an increasingly important role as the time horizon extends. We find that more than 100% of the increase since 1980 in the deterministically detrended log real value of the stock market, or a rise of 65%, is attributable to the cumulative effects of the factors share shock, which persistently redistributed rewards away from workers and toward shareholders over this period."

This is a huge result. "Indeed, without these shocks, today's stock market would be about 10% lower than it was in 1980. By contrast, technological progress that rewards both workers and shareholders plays a smaller role in historical stock market fluctuations at all horizons."

And on the risk aversion shocks? Uncorrelated with consumption or its second moments, these shocks "largely explain the long-horizon predictability of excess stock market returns found in data."

"These findings are hard to reconcile with models in which time-varying risk premia arise from habits or stochastic consumption volatility."

Massively important paper.