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Habit formation, surplus consumption and return predictability: International evidence

Listed author(s):
  • Engsted, Tom
  • Hyde, Stuart
  • Møller, Stig V.

On an international post World War II dataset, we use an iterated GMM procedure to estimate and test the Campbell and Cochrane (1999, By force of habit: a consumption-based explanation of aggregate stock market behavior. Journal of Political Economy 107, 205-251.) habit formation model with a time-varying risk-free rate. In addition, we analyze the predictive power of the surplus consumption ratio for future stock and bond returns. We find that, although there are important cross-country differences and economically significant pricing errors, for the majority of countries in our sample the model gets empirical support in a variety of different dimensions, including reasonable estimates of risk-free rates. Further, for the majority of countries the surplus consumption ratio captures time-variation in expected returns. Together with the price-dividend ratio, the surplus consumption ratio contains significant information about future stock returns, also during the 1990s. In addition, in most countries the surplus consumption ratio is also a powerful predictor of future bond returns. Thus, the surplus consumption ratio captures time-varying expected returns in both stock and bond markets.

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File URL: http://www.sciencedirect.com/science/article/pii/S0261-5606(10)00038-0
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Article provided by Elsevier in its journal Journal of International Money and Finance.

Volume (Year): 29 (2010)
Issue (Month): 7 (November)
Pages: 1237-1255

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Handle: RePEc:eee:jimfin:v:29:y:2010:i:7:p:1237-1255
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/30443

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