Consumption, risk aversion and predictability of stock returns

Abstract

This paper reports that aggregate consumption relative to past consumption forecasts substantial portions of long-horizon stock returns and subsumes most of the forecasting ability of the price-dividend ratio. Consumption relative to past consumption also forecasts time variation in the price-dividend ratio. These results are explained by a consumption-based asset pricing model. Similar to Campbell and Cochrane ( 1999), the model features a slow-moving habit and produces mean reversion in the representative agent's risk aversion. However, unlike Campbell and Cochrane ( 1999) who assume that hab it depends implicitly on current and past consumption, I specify habit as proportional to a moving average of consumption so that risk aversion varies inversely with consumption relative to past consumption.