"Rare Events" and Asset Prices

Noah Smith writes:

Noahpinion: Robot Barro?: Robert Barro is the third most cited economist in the world. He's the true inventor of "Ricardian" Equivalence, to which he was too humble to attach his own name. He's also the creator of the "rare events" theory of asset pricing, which I personally believe to be an epic win for finance theory…

Be careful...

I would note that Barro's "rare events" theory predicts that the stock market will be high when people are greatly scared of a major macroeconomic disaster in the near future. Why are stock prices then high? In the model, holding stocks is the only way to move purchasing power from the present into the future. The supply of stocks is fixed. When people fear their future income might be low because there is a high chance of a future macroeconomic disaster they frantically try to shift purchasing power into the future. They thus buy stocks. Demand for stocks is then high. Supply is fixed. And so the price of stocks is high.

Thus Barro’s “rare events” theory says that stock prices were very high in 2000 because people were then really pessimistic and terrified about the future. The dot-com bubble emerged because terrified people were willing to pay almost any price for stocks as a way of moving purchasing power from the present to the future, and thus insuring themselves against the forthcoming likely macroeconomic catastrophe.

The theory says that stock prices were low in March 2009 because people thought that the future was bright, that their future incomes were almost certain to be high, and so people were selling stocks because they did not think that they needed insurance against any future macroeconomic catastrophe.

This seems to me to get it exactly backward: when stocks are high, they are not high because people are pessimistic about the future. Rather, stocks are high when people are optimistic about the future.

Barro might say that his theory is not a theory about asset prices but about the equity premium--about the spread between stock and bond returns. He might say that his theory says that when the future is gloomy stock prices are high but bond prices are even higher, and that when the future is bright stock prices are low but bond prices are even lower, and so his theory fits the equity premium well. He might say that the fact that the theory’s predictions about the levels of asset prices are backward is not a fatal defect...