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Consumption, Aggregate Wealth, and Expected Stock Returns

Listed author(s):
  • Martin Lettau

This paper studies the role of fluctuations in the aggregate consumption-wealth ratio for predicting stock returns. Using U.S. quarterly stock market data, we find that these fluctuations in the consumption-wealth ratio 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 dividend payout ratio, and several other popular forecasting variables. Why should the consumption-wealth ratio forecast asset returns? We show that a wide class of optimal models of consumer behavior imply that the log consumption-aggregate wealth (human capital plus asset holdings) ratio summarizes expected returns on aggregate wealth, or the market portfolio. Although this ratio is not observable, we provide assumptions under which its important predictive components for future asset returns may be xpressed in terms of observable variables, namely in terms of consumption, asset holdings 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. Copyright The American Finance Association 2001.

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Article provided by American Finance Association in its journal The Journal of Finance.

Volume (Year): 56 (2001)
Issue (Month): 3 (06)
Pages: 815-849

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Handle: RePEc:bla:jfinan:v:56:y:2001:i:3:p:815-849
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  1. Campbell, John Y, 1987. "Does Saving Anticipate Declining Labor Income? An Alternative Test of the Permanent Income Hypothesis," Econometrica, Econometric Society, vol. 55(6), pages 1249-1273, November.
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  3. Clark, Todd E. & McCracken, Michael W., 2001. "Tests of equal forecast accuracy and encompassing for nested models," Journal of Econometrics, Elsevier, vol. 105(1), pages 85-110, November.
  4. 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.
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  7. John H. Cochrane, 1989. "Explaining the Variance of Price Dividend Ratios," NBER Working Papers 3157, National Bureau of Economic Research, Inc.
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