What Does the Durables Price - Over - the Rental Cost Valuation Ratio Tell Us About Asset Prices?

I propose a new valuation ratio: durables price over the rental cost of capital, which is a direct analogue of the price-dividend ratio. I show that it is a rational forecast of future discount rates and future growth rates of the rental cost. In order to impute the unobservable rental cost, I develop a dynamic rational expectations economy with Beckerian household production. Investors' preferences are defined over the nondurables and the services flow from the household capital, the stock of durables. I assume investors "produce" services flow in the household sector. I carefully model the sector's returns to scale and find decreasing returns to scale in the household capital, ceteris paribus. The result is crucial as specifications used in the previous literature lead to a misspecified rental cost of capital, and thus errors-in-variables problems in predictive regressions. In contrast to price-dividend ratio, I construct the durables price-rental cost valuation ratio as an affine function of a co-integrating residual. I evaluate its predictive power and discover that it strongly forecasts excess returns on 25 Fama-French portfolios, especially small and value stocks. In particular, I can predict small-minus-big portfolio (SMB) with $R^2$ around 30\% at 4 year horizon