Consumption Anchors Stock Prices

Aggregate stock prices and aggregate consumption share a common stochastic trend. We estimate this long-run relation in real time and recover a price--consumption cycle that captures transitory deviations of stock prices from their consumption-implied value. These deviations mean-revert over business-cycle horizons and predict future returns on the aggregate market and characteristics-sorted portfolios, both in- and out-of-sample, from one quarter to two years ahead. The cycle does not forecast consumption growth, but contains information about future dividend growth, and its return-predictive power disappears when consumption is excluded from the long-run relation. A simple model with permanent and transitory consumption shocks rationalizes these findings and the time variation in the estimated price--consumption loading. The evidence identifies consumption as a macroeconomic anchor for asset prices and departures from this anchor as a source of time-varying expected returns.