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Consumption, aggregate wealth and expected stock returns

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  • Sydney Ludvigson
  • Martin Lettau

Abstract

This paper studies the role of detrended wealth in predicting stock returns. We call a transitory movement in wealth one that produces a deviation from its shared trend with consumption and labor income. Using U.S. quarterly stock market data, we find that these trend deviations in wealth are strong predictors of both real stock returns and excess returns over a Treasury bill rate. We also find that this variable is a better forecaster of future returns at short and intermediate horizons than is the dividend yield, the earnings yield, the dividend payout ratio and several other popular forecasting variables. ; Why should wealth, detrended in this way, forecast asset returns? We show that a wide class of optimal models of consumer behavior imply that the log consumption-aggregate (human and nonhuman) wealth ratio forecasts the expected return on aggregate wealth, or the market portfolio. Although this ratio is not observable, we demonstrate that its important predictive components may be expressed in terms of observable variables, namely in terms of consumption, nonhuman wealth and labor income. The framework implies that these variables are cointegrated, and that deviations from this shared trend summarize agents' expectations of future returns on the market portfolio.

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Bibliographic Info

Paper provided by Federal Reserve Bank of New York in its series Staff Reports with number 77.

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Date of creation: 1999
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Handle: RePEc:fip:fednsr:77

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Keywords: Stock - Prices ; Wealth ; Consumption (Economics) ; Forecasting;

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  1. Fama, Eugene F. & French, Kenneth R., 1989. "Business conditions and expected returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 25(1), pages 23-49, November.
  2. Robert J. Shiller, 1984. "Stock Prices and Social Dynamics," Cowles Foundation Discussion Papers 719R, Cowles Foundation for Research in Economics, Yale University.
  3. John Y. Campbell & John H. Cochrane, 1994. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," CRSP working papers 412, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  4. Todd E. Clark & Michael W. McCracken, 1999. "Tests of equal forecast accuracy and encompassing for nested models," Research Working Paper 99-11, Federal Reserve Bank of Kansas City.
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  26. repec:fth:harver:1435 is not listed on IDEAS
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  1. US consumers: a wise crowd
    by chris dillow in Stumbling and Mumbling on 2007-09-19 09:42:39
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