Technological Growth and Asset Pricing (Preliminary and Incomplete)

In this paper we study asset pricing in the presence of technological growth. We present a model, where new technologies arrive periodically, giving firms the opportunity to plant new trees of a better vintage. The model gives rise to an endogenous technological cycle that may have a duration longer than the business cycle. In its initial phase a substantial part of the stock market valuation is driven by growth options. P/E ratios and expected returns are high, and attain a maximum once firms start to invest in the new technologies. As the economy experiences an investment driven boom, growth opportunities get exploited, leading to decreased P/E ratios and lower future expected returns. We show that the recurrence of such cycles can account jointly for a considerable number of well documented asset pricing phenomena in both the time series and the cross section of expected returns. We also show how the model can provide a micro-foundation for empirical evidence documenting that several asset pricing phenomena are driven by “long-run ” risks. In two concrete applications we show how the model can account for the weakening of cross sectional predictability between 1986-2001 and the recently documented sucess of the consumption CAPM over longer horizons