By Rui Albuquerque, Martin S. Eichenbaum and Sergio Rebelo
Standard representative-agent models have difficulty in accounting for the weak correlation between stock returns and measurable fundamentals, such as consumption and output growth. This failing underlies virtually all modern asset-pricing puzzles. The correlation puzzle arises because these models load all uncertainty onto the supply side of the economy. We propose a simple theory of asset pricing in which demand shocks play a central role. These shocks give rise to valuation risk that allows the model to account for key asset pricing moments, such as the equity premium, the bond term premium, and the weak correlation between stock returns and fundamentals.
One may want to criticize that it is easy to explain more moments by adding more shocks, but the preferences shocks here (to time preference) are disciplined by the return on risk-free bonds. This works because the shocks are aggregate, which thus opens the question why preference shocks would be coordinated in such a way. Is there some fundamental that allows such coordination? Or, if the aggregate shock is a summary of the shift in the distribution of individual preferences, is this a valid approximation? I hope this paper will trigger research along those lines, as its results are quite intriguing.