Key Points

  • Macroeconomic volatility is a useful tool in investors’ quest for the fair value of the stock market.
  • This volatility is associated with the equity risk premium: investors are willing to pay a higher price for stocks when there is lower aggregate uncertainty.
  • Macroeconomic volatility has been at historically low levels in recent years, driven largely by technological innovation, greater market integration, and improvements in monetary policy implementation.
  • Whereas lower volatility justifies a higher fair value than the historical average, the current price of the stock market still appears expensive.


The Holy Grail: A legendary relic described in various traditions as a sacred vessel with miraculous powers that provides happiness, eternal youth, and infinite abundance.

Forecasting the “fair” value of the US equity market can be likened to the legendary quest for the Holy Grail by the medieval knights of King Arthur. Valorous investors, accompanied by knowledgeable guides and equipped with various weapons such as stock market valuation metrics, routinely allocate their investment capital across markets. These allocation decisions are based on return expectations, which reflect investors’ beliefs about an asset’s fair valuation.

Contrarian investors, who profit from prices reverting to longer-term averages, are likely confounded by the continually increasing normalized value of the US equity market. Normalized prices, adjusted for changes in earnings or dividends, have remained above their long-term averages over the last quarter-century, causing a simple contrarian strategy in US equities to fail to outperform a buy-and-hold strategy over the same time period. We ask why stock valuations have been steadily increasing, will they continue to rise, and should we expect this trend to reverse itself?

We offer an economic explanation, showing that aggregate macroeconomic volatility can provide useful real-time information about the expected path of the US stock market. The falling macroeconomic volatility of major economies has led, as it should, to lower expected returns for equities, supporting the contrarian view that rising US equity valuations will eventually revert toward the mean. We show how investors can incorporate information about the changing macroeconomic environment in the construction of a contrarian strategy. Macroeconomic volatility, although not a map to the Holy Grail, offers a useful tool for investors in their quest for fair value.

The Recent Struggles of Contrarian Investors
Academics have suggested various reasons for sustained higher equity valuations, from the microstructure benefits of improved participation and lower transaction costs to the macroeconomic benefits of larger profit shares. We examine the explanation put forward by Lettau, Ludvigson, and Wachter (2008) that rising valuations are propelled by the large reduction of macroeconomic risk in the US economy. Their intuition is simple—investors require lower returns from equity markets when the aggregate volatility of the economy is lower. It should come as no surprise that investors are glad to pay a higher price, and accept a lower return for investing in a stock market that delivers less uncertainty.

Today’s economy is drastically different from just a few decades ago, and radically different from a century ago. Judging from the volatility of two major macroeconomic variables—real output growth and inflation—it has changed for the better. From the days before the US Federal Reserve Bank until today, the annual volatility of the economy has tumbled about 80%.

When we plot the measure of macro volatility with the inverse of a very popular valuation metric, Robert Shiller’s cyclically adjusted price/earnings ratio (CAPE), we find an intriguing and significant positive correlation between expected real equity returns and the aggregate volatility of the economy. Under the restrictive assumption that prices are fair and an appropriate return on retained profits, we assert that earnings yields are an appropriate proxy for an equity market’s future real return. For clarity we name the inverse of the CAPE, an earnings yield, the cyclically adjusted earnings yield (CAEY).

Quest for the Holy Grail Figure 1


The majority of the macro volatility reduction occurred during the mid-1980s at the start of the Great Moderation. Among the various explanations for this reduction in economic risk suggested by the academic research is technological innovation, greater market integration, and superior policy.

Policy planning and implementation, such as implicit or explicit inflation targeting, is likely among the more important drivers of the improved state of economic affairs. The Great Financial Recession of 2008–2009 proved that the pursuit of lower economic risk is not without its limits, although our risk measure indicates the associated rise in volatility was a minor blip on the radar screen compared to the historical record in the years preceding Paul Volcker’s appointment to the Federal Reserve in 1979.

Asness, Ilmanen, and Maloney (hereafter, AIM) (2015) argue that “secular changes can be poison to contrarian strategies, which by definition need an anchor to define where we overweight, underweight and stick close to buy-and-hold.” We would argue that simple contrarian strategies have recently underperformed a buy-and-hold strategy, precisely because they have not adapted to changes in the macroeconomic environment.