Aggregate stock prices, relative to virtually any indicator of fundamental value,
soared to unprecedented levels in the 1990s. Even today, after the market declines
since 2000, they remain well above historical norms. Why? We consider one particular
explanation: a fall in macroeconomic risk, or the volatility of the aggregate economy.
Empirically, we find a strong correlation between low frequency movements in macroeconomic
volatility and low frequency movements in the stock market. To model this phenomenon,
we estimate a two-state regime switching model for the volatility and mean of consumption
growth, and find evidence of a shift to substantially lower consumption volatility
at the beginning of the 1990s. We then use these estimates from post-war data to
calibrate a rational asset pricing model with regime switches in both the mean and
standard deviation of consumption growth. Plausible parameterizations of the model
are found to account for a significant portion of the run-up in asset valuation ratios
observed in the late 1990s.