High Returns On Us Equities Reflect Expectations Of Possible Disaster

Why are the returns to US equities so much higher than is justified by their riskiness compared to other assets like cash and bonds? According to Professors Jean-Pierre Danthine and John Donaldson, writing in the latest issue of the Economic Journal, the puzzingly large ”equity premium” observed in the United States may result from the expectations of a disaster event – or set of events – which happens not to have materialised. Their research confirms that the high historical premium in the United States is unique. They conjecture that it may be attributable to the fact that disastrous events affecting other financial markets (such as World War II for Japan, Germany and other European countries) have largely bypassed the American economy.

The researchers argue that it is not unreasonable to think that the experience of the Great Depression continues to have a significant influence on the behaviour of those who experienced it directly or indirectly, even though it has not recurred in 65 years. Similarly, the fear of 1929 – although not borne out – or of a much-talked-about-but-never-experienced systemic financial meltdown, may have been significant in the crash of October 1987 as well as in October 1997. In other words, these events may have loomed larger in investors” beliefs than their ”objective” probability as assessed on the basis of recent history. The fact that they have not materialised in the post-war period does not prove that the possibility of their occurrence has not affected behaviour.

The researchers do not want to argue that this is the solution to the equity premium puzzle. By the nature of their exercise, it will never be possible to prove that catastrophic expectations were indeed part of market participants” information sets. Nevertheless, they show that traditional results are highly sensitive to small and plausible perturbations in expectations. In that light, not only is the US equity premium less of a puzzle, but it is also less surprising that there are large variations in equity premia across time periods and geographical locations.

”Non-Falsified Expectations and General Equilibrium Asset Pricing: The Power of the Peso” by Jean-Pierre Danthine and John Donaldson is published in the October 1999 issue of the Economic Journal. Danthine is at the University of Lausanne; Donaldson at Columbia University.

Jean-Pierre Danthine