Consumption-Wealth Ratio and Expected Stock Returns: Evidence from Panel Data on G7 Countries

Using the theoretical framework of Lettau and Ludvigson (2001), we perform anempirical investigation on how widespread is the predictability of cay - a modifiedconsumption-wealth ratio - once we consider a set of important countries from aglobal perspective. We chose to work with the set of G7 countries, which representmore than 64% of net global wealth and 46% of global GDP at market exchangerates. We evaluate the forecasting performance of cay using a panel-data approach,since applying cointegration and other time-series techniques is now standard practice in the panel-data literature. Hence, we generalize Lettau and Ludvigson's testsfor a panel of important countries.We employ macroeconomic and financial quarterly data for the group of G7countries, forming an unbalanced panel. For most countries, data is available fromthe early 1990s until 2014Q1, but for the U.S. economy it is available from 1981Q1through 2014Q1.Results of an exhaustive empirical investigation are overwhelmingly in favor ofthe predictive power of cay in forecasting future stock returns and excess returns.