CAN A WELL-FITTED EQUILIBRIUM ASSET-PRICING MODEL PRODUCE MEAN REVERSION

In recent papers, Cecchetti et al. (1990) and Kandel and Stambaugh (19 90) showed that negative serial correlation in long horizon returns wa s consistent with an equilibrium model of asset pricing. In this paper , we show that their results rely on misspecified Markov switching mod els for the endowment process. Once the proper Markov specification is chosen for the endowment process, the model does not produce mean rev ersion of the magnitude detected in the data. Furthermore, the small a mount of mean reversion produced by the model is due only to small sam ple bias. We also show that this model is unable to predict negative e xcess returns, contrary to empirical evidence.