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Consumption, Aggregate Wealth and Expected Stock Returns

  • Lettau, Martin
  • Ludvigson, Sydney

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 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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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 2223.

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Date of creation: Sep 1999
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Handle: RePEc:cpr:ceprdp:2223
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  1. Cochrane, John H., 1991. "Volatility tests and efficient markets : A review essay," Journal of Monetary Economics, Elsevier, vol. 27(3), pages 463-485, June.
  2. Phillips, Peter C B & Ouliaris, S, 1990. "Asymptotic Properties of Residual Based Tests for Cointegration," Econometrica, Econometric Society, vol. 58(1), pages 165-93, January.
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  12. Campbell, John, 1987. "Stock Returns and the Term Structure," Scholarly Articles 3207699, Harvard University Department of Economics.
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  18. John Y. Campbell, 1990. "A Variance Decomposition for Stock Returns," NBER Working Papers 3246, National Bureau of Economic Research, Inc.
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  31. repec:fth:harver:1435 is not listed on IDEAS
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