The Nature of Structural Break in the U.S. Stock Market

Using the monthly excess returns on the value weighted portfolio of NYSE stocks for the period of 1926:1 - 1998:12, we investigate a positive relationship between the equity premium and volatility over long and short horizons. One possibility is that structural shifts in long run or low-frequency volatility are associated with shifts in equity premium. Another possibility is that the equity premium changes with high-frequency fluctuations in volatility in the form of the volatility feedback effect. Assuming one-time, permanent endogenous structural break in the sample, we investigate the two possibilities within the Bayesian framework. We show that once the structural break in the volatility-generating process and the volatility feedback effect are controlled for, evidence of structural break in the equity premium disappears. This confirms the importance of the volatility feedback effect in explaining a positive link between equity premium and volatility. In addition, we contend that the volatility feedback effect is the major source of mean reversion reported in the literature.