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Abstract:
This paper explores the ability of theoretically based asset pricing models such as the CAPM and the consumption CAPM-referred to jointly as the (C)CAPM-to explain the cross-section of average stock returns. Unlike many previous empirical tests of the (C)CAPM, we specify the pricing kernel as a conditional linear factor model, as would be expected if risk premia vary over time. Central to our approach is the use of a conditioning variable which proxies for fluctuations in the log consumption-aggregate wealth ratio and is likely to be important for summarizing conditional expectations of excess returns. We demonstrate that such conditional factor models are able to explain a substantial fraction of the cross-sectional variation in portfolio returns. These models perform much better than unconditional (C)CAPM specifications, and about as well as the three-factor Fama-French model on portfolios sorted by size and book-to-market ratios. This specification of the linear conditional consumption CAPM, using aggregate consumption data, is able to account for the difference in returns between low book-to-market and high book-to-market firms and exhibits little evidence of residual size or book-to-market effects.

Abstract:
Aggregate stock prices, relative to virtually any indicator of fundamental value, soared to unprecedented levels in the 1990s. Even today, after the market declines since 2000, they remain well above historical norms. Why? We consider one particular explanation: a fall in macroeconomic risk, or the volatility of the aggregate economy. We estimate a two-state regime switching model for the volatility and mean of consumption growth, and find evidence of a shift to substantially lower consumption volatility at the beginning of the 1990s. We then show that there is a strong and statistically robust correlation between low macroeconomic volatility and high asset prices: the estimated posterior probability of being in a low volatility state explains 30 to 60 percent of the post-war variation in the log price-dividend ratio, depending on the measure of consumption analyzed. Next, we study a rational asset pricing model with regime switches in both the mean and standard deviation of consumption growth, where the probabilities of a regime change are calibrated to match estimates from post-war data. Plausible parameterizations of the model are found to account for a significant fraction of the run-up in asset valuation ratios observed in the late 1990s.

Abstract:
Aggregate stock prices, relative to virtually any indicator of fundamental value, soared to unprecedented levels in the 1990s. Even today, after the market declines since 2000, they remain well above historical norms. Why? We consider one particular explanation: a fall in macroeconomic risk, or the volatility of the aggregate economy. Empirically, we find a strong correlation between low-frequency movements in macroeconomic volatility and low-frequency movements in the stock market. To model this phenomenon, we estimate a two-state regime switching model for the volatility and mean of consumption growth, and find evidence of a shift to substantially lower consumption volatility at the beginning of the 1990s. We then use these estimates from postwar data to calibrate a rational asset pricing model with regime switches in both the mean and standard deviation of consumption growth. Plausible parameterizations of the model are found to account for a significant portion of the run-up in asset valuation ratios observed in the late 1990s.

G12

Abstract:
Aggregate stock prices, relative to virtually any indicator of fundamental value, soared to unprecedented levels in the 1990s. Even today, after the market declines since 2000, they remain well above historical norms. Why? We consider one particular explanation: a fall in macroeconomic risk, or the volatility of the aggregate economy. Empirically, we find a strong correlation between low frequency movements in macroeconomic volatility and low frequency movements in the stock market. To model this phenomenon, we estimate a two-state regime switching model for the volatility and mean of consumption growth, and find evidence of a shift to substantially lower consumption volatility at the beginning of the 1990s. We then use these estimates from post-war data to calibrate a rational asset pricing model with regime switches in both the mean and standard deviation of consumption growth. Plausible parameterizations of the model are found to account for a significant portion of the run-up in asset valuation ratios observed in the late 1990s.

Equity premium, macroeconomic volatility, stock market boom, regime shifts

Abstract:
Aggregate stock prices, relative to virtually any indicator of fundamental value, soared to unprecedented levels in the 1990s. Even today, after the market declines since 2000, they remain well above historical norms. Why? We consider one particular explanation: a fall in macroeconomic risk, or the volatility of the aggregate economy. Empirically, we find a strong correlation between low frequency movements in macroeconomic volatility and low frequency movements in the stock market. To model this phenomenon, we estimate a two-state regime switching model for the volatility and mean of consumption growth, and find evidence of a shift to substantially lower consumption volatility at the beginning of the 1990s. We then use these estimates from post-war data to calibrate a rational asset pricing model with regime switches in both the mean and standard deviation of consumption growth. Plausible parameterizations of the model are found to account for a significant portion of the run-up in asset valuation ratios observed in the late 1990s.

Abstract:
Aggregate stock prices, relative to virtually any indicator of fundamental value, soared to unprecedented levels in the 1990s. Even today, after the market declines since 2000, they remain well above historical norms. Why? We consider one particular explanation: a fall in macroeconomic risk, or the volatility of the aggregate economy. We estimate a two-state regime switching model for the volatility and mean of consumption growth, and find evidence of a shift to substantially lower consumption volatility at the beginning of the 1990s. We then show that there is a strong and statistically robust correlation between low macroeconomic volatility and high asset prices: the estimated posterior probability of being in a low volatility state explains 30 to 60 percent of the post-war variation in the log price-dividend ratio, depending on the measure of consumption analyzed. Next, we study a rational asset pricing model with regime switches in both the mean and standard deviation of consumption growth, where the probabilities of a regime change are calibrated to match estimates from post-war data. Plausible parameterizations of the model are found to account for a significant fraction of the run-up in asset valuation ratios observed in the late 1990s.

Abstract:
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 U.S. 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.

Abstract:
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 U.S. 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.

Abstract:
We develop a consumption-based present value relation that is a function of future dividend growth. Using data on aggregate consumption and measures of the dividend payments from aggregate wealth, we show that changing forecasts of dividend growth make an important contribution to fluctuations in the U.S. stock market, despite the failure of the dividend-price ratio to uncover such variation. In addition, these dividend forecasts are found to covary with changing forecasts of excess stock returns. The variation in expected dividend growth we uncover is positively correlated with "business cycle" variation in expected returns, and the results suggest that a substantial fraction of the variation in expected dividend growth is common to variation in expected excess returns. Movements in expected dividend growth that are entirely common to movements in expected returns have no effect on the log dividend-price ratio. An implication of these findings is that the log dividend-price ratio will have difficulty predicting both dividend growth and excess returns at business cycle frequencies. Such a failure of predictive power is not an indication that risk-premia are constant, however. On the contrary, the results presented here imply that the log dividend-price ratio will have difficulty revealing business cycle variation in both the equity risk-premium and expected dividend growth precisely because expected returns fluctuate at those frequencies, and covary with changing forecasts of dividend growth. The findings imply that both the market risk- premium and expected dividend growth vary considerably more than what can be revealed using the log dividend-price ratio alone as a predictive variable.

Abstract:
A key criticism of the existing empirical literature on the risk-return relation relates to the relatively small amount of conditioning information used to model the conditional mean and conditional volatility of excess stock market returns. To the extent that financial market participants have information not reflected in the chosen conditioning variables, measures of conditional mean and conditional volatility - and ultimately the risk-return relation itself - will be misspecified and possibly highly misleading. We consider one remedy to these problems using the methodology of dynamic factor analysis for large datasets, whereby a large amount of economic information can be summarized by a few estimated factors. We find that three new factors, a "volatility", "risk premium", and "real" factor, contain important information about one-quarter ahead excess returns and volatility that is not contained in commonly used predictor variables. Moreover, the factor-augmented specifications we examine predict an unusual 16-20 percent of the one-quarter ahead variation in excess stock market returns, and exhibit remarkably stable and strongly statistically significant out-of-sample forecasting power. Finally, in contrast to several pre-existing studies that rely on a small number of conditioning variables, we find a positive conditional correlation between risk and return that is strongly statistically significant, whereas the unconditional correlation is weakly negative and statistically insignificant.

Abstract:
A key criticism of the existing empirical literature on the risk-return relation relates to the relatively small amount of conditioning information used to model the conditional mean and conditional volatility of excess stock market returns. To the extent that financial market participants have information not reflected in the chosen conditioning variables, measures of conditional mean and conditional volatility - and ultimately the risk-return relation itself - will be misspecified and possibly highly misleading. We consider one remedy to these problems using the methodology of dynamic factor analysis for large datasets, whereby a large amount of economic information can be summarized by a few estimated factors. We find that three new factors, a volatility, risk premium, and real factor, contain important information about one-quarter ahead excess returns and volatility that is not contained in commonly used predictor variables. Moreover, the factor-augmented specifications we examine predict an unusual 16-20 percent of the one-quarter ahead variation in excess stock market returns, and exhibit remarkably stable and strongly statistically significant out-of-sample forecasting power. Finally, in contrast to several pre-existing studies that rely on a small number of conditioning variables, we find a positive conditional correlation between risk and return that is strongly statistically significant, whereas the unconditional correlation is weakly negative and statistically insignificant.

Risk-premia, excess returns, stock market volatility

Abstract:
This study examines the out-of-sample predictive power of fluctuations in the aggregate consumption wealth ratio in one-quarter-ahead forecasts of excess stock returns. We find that observations of the aggregate consumption wealth ratio would have consistently improved forecasts of excess stock returns in post-war data relative to a variety of alternative forecasting models. Furthermore, this improvement in out-of-sample predictive is found to be statistically significant according to a variety of statistical tests.

Abstract:
Among the most important pieces of empirical evidence against the standard representative agent, consumption-based asset pricing paradigm are the formidable unconditional Euler equation errors the model produces for cross-sections of asset returns. Here we ask whether calibrated leading asset pricing models- specifically developed to address empirical puzzles associated with the standard paradigm- explain the mispricing of the standard consumption-based model when evaluated on cross-sections of asset returns. We find that, in many cases, they do not. We present several results. First, we show that if the true pricing kernel that sets the unconditional Euler equation errors to zero is jointly lognormally distributed with aggregate consumption and returns, such a kernel will not rationalize the magnitude of the pricing errors generated by the standard model, particularly when the curvature of utility is high. Second, we show that leading asset pricing models also do not explain the significant mispricing of the standard paradigm for plausibly calibrated sets of asset returns, even though in those models the pricing kernel, returns, and consumption are not jointly lognormally distributed. Third, in contrast to the above results, we provide one example of a limited participation/incomplete markets model capable of explaining larger pricing errors for the standard model; but we also find many examples of such models, in which the consumption of marginal assetholders behaves quite differently from per capita aggregate consumption, that do not explain the large Euler equation errors of the standard representative agent model.

Abstract:
The standard, representative agent, consumption-based asset pricing theory based on CRRA utility fails to explain the average returns of risky assets. When evaluated on cross sections of stock returns, the model generates economically large unconditional Euler equation errors. Unlike the equity premium puzzle, these large Euler equation errors cannot be resolved with high values of risk aversion. To explain why the standard model fails, we need to develop alternative models that can rationalize its large pricing errors. We evaluate whether four newer theories at the vanguard of consumption-based asset pricing can explain the large Euler equation errors of the standard consumption-based model. In each case, we find that the alternative theory counterfactually implies that the standard model has negligible Euler equation errors. We show that a simple model in which aggregate consumption growth and stockholder consumption growth are highly correlated most of the time, but have low or negative correlation in severe recessions, produces violations of the standard model's Euler equations and departures from joint log normality that are remarkably similar to those found in the data.

Abstract:
The standard, representative agent, consumption-based asset pricing theory based on CRRA utility fails to explain the average returns of risky assets. When evaluated on cross- sections of stock returns, the model generates economically large unconditional Euler equation errors. Unlike the equity premium puzzle, these large Euler equation errors cannot be resolved with high values of risk aversion. To explain why the standard model fails, we need to develop alternative models that can rationalize its large pricing errors. We evaluate whether four newer theories at the vanguard of consumption-based asset pricing can explain the large Euler equation errors of the standard consumption-based model. In each case, we find that the alternative theory counterfactually implies that the standard model has negligible Euler equation errors. We show that the models miss on this dimension because they mischaracterize the joint behavior of consumption and asset returns in recessions, when aggregate consumption is falling. By contrast, a simple model in which aggregate consumption growth and stockholder consumption growth are highly correlated most of the time, but have low or negative correlation in severe recessions, produces violations of the standard model's Euler equations and departures from joint lognormality that are remarkably similar to those found in the data.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Abstract:
Among the most important pieces of empirical evidence against the standard representative agent, consumption-based asset pricing paradigm are the formidable unconditional Euler equation errors the model produces for cross-sections of asset returns. Here we ask whether calibrated leading asset pricing models - specifically developed to address empirical puzzles associated with the standard paradigm - explain the mispricing of the standard consumption-based model when evaluated on cross-sections of asset returns. We find that, in many cases, they do not. We present several results. First, we show that if the true pricing kernel that sets the unconditional Euler equation errors to zero is jointly lognormally distributed with aggregate consumption and returns, such a kernel will not rationalize the magnitude of the pricing errors generated by the standard model, particularly when the curvature of utility is high. Second, we show that leading asset pricing models also do not explain the significant mispricing of the standard paradigm for plausibly calibrated sets of asset returns, even though in those models the pricing kernel, returns, and consumption are not jointly lognormally distributed. Third, in contrast to the above results, we provide one example of a limited participation/incomplete markets model capable of explaining larger pricing errors for the standard model; but we also find many examples of such models, in which the consumption of marginal assetholders behaves quite differently from per capita aggregate consumption, that do not explain the large Euler equation errors of the standard representative agent model.

Consumption CAPM and pricing errors

Abstract:
The standard, representative agent, consumption-based asset pricing theory based on CRRA utility fails to explain the average returns of risky assets. This is evident from the large unconditional Euler equation errors, or pricing errors (terms we use interchangeably), that the model generates when evaluated on cross-sections of stock returns. To understand why the standard model fails, we need alternative models that explain its mispricing. We ask whether four alternative models at the vanguard of consumption-based asset pricing theory explain the standard model's large pricing errors. We find that, in each case, the alternative theories counterfactually imply that the standard model generates negligible asset pricing errors when evaluated on empirically plausible cross-sections of stock returns. In contrast to these results, we provide a stylized example of a limited participation/incomplete markets model capable of rationalizing the pricing errors of the standard consumption-based model; but we also find many examples of such models, in which the consumption of marginal assetholders behaves quite differently from per capita aggregate consumption, that do not explain the large Euler equation errors of the standard representative agent model.

Pricing errors, consumption-based asset pricing, CRRA utility

Abstract:
A popular explanation of aggregate stock market behavior suggests that assets are priced as if there were a representative investor whose utility is a power function of the difference between aggregate consumption and a habit level, where the habit is some function of lagged and (possibly) contemporaneous consumption. But theory does not provide precise guidelines about the parametric functional relationship between the habit and aggregate consumption. This makes formal estimation and testing challenging; at the same time, it raises an empirical question about the functional form of the habit that best explains asset pricing data. This paper studies the ability of a general class of habit-based asset pricing models to match the conditional moment restrictions implied by asset pricing theory. Our approach is to treat the functional form of the habit as unknown, and to estimate it along with the rest of the models finite dimensional parameters. This semiparametric approach allows us to empirically evaluate a number of interesting hypotheses about the specification of habit-based asset pricing models. Using stationary quarterly data on consumption growth, assets returns and instruments, our empirical results indicate that the estimated habit function is nonlinear, the habit formation is internal, and the estimated time-preference parameter and the power utility parameter are sensible. In addition, our estimated habit function generates a positive stochastic discount factor (SDF) proxy and performs well in explaining cross-sectional stock return data. We find that an internal habit SDF proxy can explain a cross-section of size and book-market sorted portfolio equity returns better than (i) the Fama and French (1993) three-factor model, (ii) the Lettau and Ludvigson (2001b) scaled consumption CAPM model, (iii) an external habit SDF proxy, (iv) the classic CAPM, and (v) the classic consumption CAPM.

Abstract:
A popular explanation of aggregate stock market behavior suggests that assets are priced as if there were a representative investor whose utility is a power function of the difference between aggregate consumption and a "habit" level, where the habit is some function of lagged and (possibly) contemporaneous consumption. But theory does not provide precise guidelines about the parametric functional relationship between the habit and aggregate consumption. This makes formal estimation and testing challenging; at the same time, it raises an empirical question about the functional form of the habit that best explains asset pricing data.

This paper studies the ability of a general class of habit-based asset pricing models to match the conditional moment restrictions implied by asset pricing theory. Our approach is to treat the functional form of the habit as unknown, and to estimate it along with the rest of the model's finite dimensional parameters. This semiparametric approach allows us to empirically evaluate a number of interesting hypotheses about the specification of habit-based asset pricing models. Using stationary quarterly data on consumption growth, assets returns and instruments, our empirical results indicate that the estimated habit function is nonlinear, the habit formation is internal, and the estimated time-preference parameter and the power utility parameter are sensible. In addition, our estimated habit function generates a positive stochastic discount factor (SDF) proxy and performs well in explaining cross-sectional stock return data . We find that an internal habit SDF proxy can explain a cross-section of size and book-market sorted portfolio equity returns better than (i) the Fama and French (1993) three-factor model, (ii) the Lettau and Ludvigson (2001b) scaled consumption CAPM model, (iii) an external habit SDF proxy, (iv) the classic CAPM, and (v) the classic consumption CAPM.

Abstract:
This article is the first formal investigation of consumer attitudes that compares the forecasting power of the University of Michigan's Index of Consumer Sentiment and the Conference Board's Consumer Confidence Index. The authors find that measures available from the Conference Board have both economically and statistically significant explanatory power for several categories of consumer spending. By contrast, measures available from the University of Michigan generally exhibit weaker forecasting power for most categories of spending. As part of their analysis, the authors examine the ways in which the surveys underlying these measures differ and test whether certain types of survey questions are particularly important for predicting consumer spending.

consumber confidence, household expenditures

Abstract:
A paper presented at the April 2001 conference "Financial Innovation and Monetary Transmission," sponsored by the Federal Reserve Bank of New York.

monetary policy transmission

Abstract:
We develop a consumption-based present value relation that is a function of future dividend growth. Using data on aggregate consumption and measures of the dividend payments from aggregate wealth, we show that changing forecasts of dividend growth make an important contribution to fluctuations in the U.S. stock market, despite the failure of the dividend-price ratio to uncover such variation. In addition, these dividend forecasts are found to covary with changing forecasts of excess stock returns. The variation in expected dividend growth we uncover is positively correlated with "business cycle" variation in expected returns, and the results suggest that a substantial fraction of the variation in expected dividend growth is common to variation in expected excess returns. Movements in expected dividend growth that are entirely common to movements in expected returns have no effect on the log dividend-price ratio. An implication of these findings is that the log dividend-price ratio will have difficulty predicting both dividend growth and excess returns at business cycle frequencies. Such a failure of predictive power is not an indication that risk-premia are constant, however. On the contrary, the results presented here imply that the log dividend-price ratio will have difficulty revealing business cycle variation in both the equity risk-premium and expected dividend growth precisely because expected returns fluctuate at those frequencies, and covary with changing forecasts of dividend growth. The findings imply that both the market risk-premium and expected dividend growth vary considerably more than what can be revealed using the log dividend-price ratio alone as a predictive variable.

Abstract:
We develop a consumption-based present value relation that is a function of future dividend growth. Using data on aggregate consumption and measures of the dividend payments from aggregate wealth, we show that changing forecasts of dividend growth make an important contribution to fluctuations in the U.S. stock market, despite the failure of the dividend-price ratio to uncover such variation. In addition, these dividend forecasts are found to covary with changing forecasts of excess stock returns. The variation in expected dividend growth we uncover is positively correlated with "business cycle" variation in expected returns, and the results suggest that a substantial fraction of the variation in expected dividend growth is common to variation in expected excess returns. Movements in expected dividend growth that are entirely common to movements in expected returns have no effect on the log dividend-price ratio. An implication of these findings is that the log dividend-price ratio will have difficulty predicting both dividend growth and excess returns at business cycle frequencies. Such a failure of predictive power is not an indication that risk-premia are constant, however. On the contrary, the results presented here imply that the log dividend-price ratio will have difficulty revealing business cycle variation in both the equity risk-premium and expected dividend growth precisely because expected returns fluctuate at those frequencies, and covary with changing forecasts of dividend growth. The findings imply that both the market risk-premium and expected dividend growth vary considerably more than what can be revealed using the log dividend-price ratio alone as a predictive variable.

Abstract:
We investigate a consumption-based present value relation that is a function of future dividend growth. Using data on aggregate consumption and measures of the dividend payments from aggregate wealth, we show that changing forecasts of dividend growth are an important feature of the post-war U.S. stock market, despite the failure of the dividend-price ratio to uncover such variation. In addition, these dividend forecasts are found to covary with changing forecasts of excess stock returns. The variation in expected dividend growth we uncover is positively correlated with changing forecasts of excess returns and occurs at business cycle frequencies, those ranging from one to six years. This covariation is important because positively correlated fluctuations in expected dividend growth and expected returns have offsetting affects on the log dividend-price ratio. The results therefore imply that both the market risk-premium and expected dividend growth vary considerably more than what can be revealed using the log dividend-price ratio alone as a predictive variable.

Risk premia, dividend growth, cash-flow predictability, return predictability

Abstract:
We develop a consumption-based present value relation that is a function of future dividend growth. Using data on aggregate consumption and measures of the dividend payments from aggregate wealth, we show that changing forecasts of dividend growth make an important contribution to fluctuation's in the U.S. stock market, despite the failure of the dividend price ratio to uncover such variation. In addition, these dividend forecasts are found to co-vary with changing forecasts of excess stock returns. The variation in expected dividend growth we uncover is positively correlated with business cycle variation in expected returns, and the results suggest that a substantial fraction of the variation in expected dividend growth is common to variation in expected excess returns. Movements in expected dividend growth that are entirely common to movements in expected returns haveno effect on the log dividend-price ratio. An implication of these findings is that the log dividend-price ratio will have difficulty predicting both dividend growth and excess returns at business cycle frequencies. Such a failure of predictive power is not an indication that risk-premia are constant, however. On the contrary, the results presented here imply that the log dividend-price ratio will have difficulty revealing business cycle variation in both the equity risk-premium and expected dividend growth precisely because expected returns fluctuate at those frequencies, and co-vary with changing forecasts of dividend growth. The findings imply that both the market risk premium and expected dividend growth vary considerably more than what can be revealed using the log dividend-price ratio alone as a predictive variable.

Abstract:
We investigate a consumption-based present value relation that is a function of future dividend growth. Using data on aggregate consumption and measures of the dividend payments from aggregate wealth, we show that changing forecasts of dividend growth make an important contribution to fluctuations in the U.S. stock market, despite the failure of the dividend-price ratio to uncover such variation. In addition, these dividend forecasts are found to covary with changing forecasts of excess stock returns. The variation in expected dividend growth we uncover is positively correlated with changing forecasts of excess returns and occurs at business cycle frequencies, those ranging from one to six years. Because positively correlated fluctuations in expected dividend growth and expected returns have offsetting affects on the log dividend-price ratio, the results imply that both the market risk-premium and expected dividend growth vary considerably more than what can be revealed using the log dividend-price ratio alone as a predictive variable.

Abstract:
We develop a consumption-based present value relation that is a function of future dividend growth. Using data on aggregate consumption and measures of the dividend payments from aggregate wealth, we show that changing forecasts of dividend growth make an important contribution to fluctuations in the US stock market, despite the failure of the dividend-price ratio to uncover such variation. In addition, these dividend forecasts are found to co-vary with changing forecasts of excess stock returns. The variation in expected dividend growth we uncover is positively correlated with 'business cycle' variation in expected returns, and the results suggest that a substantial fraction of the variation in expected dividend growth is common to variation in expected excess returns. Movements in expected dividend growth that are entirely common to movements in expected returns have no effect on the log dividend-price ratio. An implication of these findings is that the log dividend-price ratio will have difficulty predicting both dividend growth and excess returns at business cycle frequencies. Such a failure of predictive power is not an indication that risk-premia are constant, however. On the contrary, the results presented here imply that the log dividend-price ratio will have difficulty revealing business cycle variation in both the equity risk-premium and expected dividend growth precisely because expected returns fluctuate at those frequencies, and co-vary with changing forecasts of dividend growth. The findings imply that both the market risk-premium and expected dividend growth vary considerably more than what can be revealed using the log dividend-price ratio alone as a predictive variable.

Dividend growth, consumption, cointegration

Abstract:
The buffer-stock model of precautionary saving has become a workhorse of modern-day consumer theory. Despite its growing popularity, virtually no research has set out to formally investigate whether buffer-stock behavior can replicate the well-known smoothness of aggregate consumption growth ("excess smoothness"), or its correlation with lagged income ("excess sensitivity"). We investigate an aggregate version of the standard buffer stock model and examine how its predictions vary according to whether individuals observe economy-wide variation in their income. Our results show that, when individuals observe each component of their income, aggregate buffer stock consumption growth is at least as volatile as aggregate income growth and insignificantly correlated with lagged income growth. We show that adding incomplete information about aggregate income goes part of the way toward resolving these discrepancies, but still falls short of matching the data in magnitude. In particular, buffer stock saving creates a smoothness puzzle for aggregate consumption that remains to be explained.

Abstract:
The buffer-stock model of precautionary saving has become a workhorse of modern-day consumer theory. Despite its growing popularity, virtually no research has set out to formally investigate whether buffer-stock behavior can replicate the well-known smoothness of aggregate consumption growth ("excess smoothness"), or its correlation with lagged income ("excess sensitivity"). We investigate an aggregate version of the standard buffer stock model and examine how its predictions vary according to whether individuals observe economy-wide variation in their income. Our results show that, when individuals observe each component of their income, aggregate buffer stock consumption growth is at least as volatile as aggregate income growth and insignificantly correlated with lagged income growth. We show that adding incomplete information about aggregate income goes part of the way toward resolving these discrepancies, but still falls short of matching the data in magnitude. In particular, buffer stock saving creates a smoothness puzzle for aggregate consumption that remains to be explained.

Abstract:
This paper constructs a simple model of home production that demonstrates the connection between the intertemporal elasticity of substitution in market consumption (IES) and the static elasticity of substitution between home and market consumption (SES), when the utility function is additively separable over home and market consumption. Understanding this connection is important because there is a large body of empirical evidence suggesting that the IES is small, but little evidence on the size of the SES. We use our framework to shed light on the properties of a home production model with a low IES. We find that such a model must have two fundamental properties in order to match key aspects of the U.S. aggregate data. First, the steady-state growth rate of technology must be the same across sectors. Second, shocks to technology must be sufficiently positively correlated across sectors.

Abstract:
This paper constructs a simple model of home production that demonstrates the connection between the intertemporal elasticity of substitution in market consumption (IES) and the static elasticity of substitution between home and market consumption (SES), when the utility function is additively separable over home and market consumption. Understanding this connection is important because there is a large body of empirical evidence suggesting that the IES is small, but little evidence on the size of the SES. We use our framework to shed light on the properties of a home production model with a low IES. We find that such a model must have two fundamental properties in order to match key aspects of the U.S. aggregate data. First, the steady-state growth rate of technology must be the same across sectors. Second, shocks to technology must be sufficiently positively correlated across sectors.

Abstract:
Many argue that the astonishing growth in Americans' stock portfolios in the 1990s has been a major force behind the growth of consumer spending. This article reviews the relationship between stock market movements and consumption. Using various econometric techniques and specifications, the authors find that the propensity to consume out of aggregate household wealth has exhibited instability over the postwar period. They also show that the dynamic response of consumption growth to an unexpected change in wealth is extremely short-lived, implying that forecasts of consumption growth one or more quarters ahead are not typically improved by accounting for changes in existing wealth. Finally, the impact effect of a wealth shock on consumption growth, while statistically positive, is found to be uncertain. Although recent market gains have provided support for consumer spending, the authors' findings are too limited to encourage reliance on estimates of the stock market effect in macroeconomic forecasts.

stock markets, consumption

Abstract:
This paper explores the ability of theoretically based asset pricing models such as the CAPM and the consumption CAPM-referred to jointly as the (C)CAPM - to explain the cross-section of average stock returns. Unlike many previous empirical tests of the (C)CAPM, we specify the pricing kernel as a conditional linear factor model, as would be expected if risk premia vary over time. Central to our approach is the use of a conditioning variable which proxies for fluctuations in the log consumption-aggregate wealth ratio and is likely to be important for summarizing conditional expectations of excess returns. We demonstrate that such conditional factor models are able to explain a substantial fraction of the cross-sectional variation in portfolio returns. These models perform much better than unconditional (C)CAPM specifications, and about as well as the three-factor Fama-French model on portfolios sorted by size and book-to-market ratios. This specification of the linear conditional consumption CAPM, using aggregate consumption data, is able to account for the difference in returns between low book-to-market and high book-to-market firms and exhibits little evidence of residual size or book-to-market effects.

Abstract:
This paper presents estimates of key preference parameters of the Epstein and Zin (1989, 1991) and Weil (1989) (EZW) recursive utility model, evaluates the model's ability to fit asset return data relative to other asset pricing models, and investigates the implication of such estimates for the unobservable aggregate wealth return. Our empirical results indicate that the estimated relative risk aversion parameter is high, ranging from 17-60, with higher values for aggregate consumption than for stockholder consumption, while the estimated elasticity of intertemporal substitution is above one. In addition, the estimated model-implied aggregate wealth return is found to be weakly correlated with the CRSP value-weighted stock market return, suggesting that the return to human wealth is negatively correlated with the aggregate stock market return. In quarterly data from 1952 to 2005, we find that an SMD estimated EZW recursive utility model can explain a cross-section of size and book-market sorted portfolio equity returns better than the standard consumption-based model based on power utility and about as well as the Lettau and Ludvigson (2001b) cay-scaled consumption CAPM model, but not as well as models based on financial factors such as the Fama and French (1993) three-factor model.

Abstract:
We study the role of information in asset pricing models with long-run cash flow risk. To illustrate the importance of the information structure, we show how the implications of the long-run risk paradigm for the cross-sectional properties of stock returns and cash flow duration are affected by information. When investors can fully distinguish short- and long-run consumption risk components of dividend growth innovations (full information), only exposure to long-run consumption risk generates significant risk premia, implying that high-return value stocks are long-duration assets, contrary to the historical data. By contrast, when investors observe the change in consumption and dividends each period but not the individual components of that change (limited information), exposure to short-run risk can generate large risk premia, so that high-return value stocks are short-duration assets while low-return growth stocks are long-duration assets, as in the data. We also show that, in order to explain empirical finding that long-horizon equity is less risky than short-horizon equity, the properties of the cash flow model and the values of primitive preference parameters must be quite different from those emphasized in the existing long-run risk literature.

Abstract:
In a recent paper ("A Primer on the Economics and Time Series Econometrics of Wealth Effects," 2001), Davis and Palumbo investigate the empirical relation between three cointegrated variables: aggregate consumption, asset wealth, and labor income. Although cointegration implies that an equilibrium relation ties these variables together in the long run, the authors focus on the following structural question about the short-run dynamics: "How quickly does consumption adjust to changes in income and wealth? Is the adjustment rapid, occurring within a quarter, or more sluggish, taking place over many quarters?" The authors claim that their findings answer this question, and imply that spending adjusts only gradually after gains or losses in income or wealth have been realized. We argue here, however, that a statistical methodology different from that used by Davis and Palumbo is required to address these questions, and that once it has been employed, the resulting empirical evidence weighs considerably against their interpretation of the data.

wealth effect, cointegretion, permanent income

Abstract:
This Paper uses restrictions implied by cointegration to identify the permanent and transitory elements (the 'trend' and 'cycle') of household asset wealth. Our empirical analysis yields answers to the following questions: 1. Is there a large transitory component in household net worth or is wealth close to a random walk? Our point estimates imply that a striking 85% of the post-war variation in the growth of household net worth is transitory, attributable to fluctuations in the stock market component of wealth. Transitory wealth shocks are quite persistent, affecting asset values for a number of years. This transitory element picks out the 'bull markets' of the late 1960s and 1990s, and the 'bear' markets of the 1970s. If markets are efficient, these transitory fluctuations must be attributable to time-variation in the required rate of return on assets (discount rates). 2. How is transitory variation in household net worth related to consumer spending? Does consumption adapt with a lag to permanent movements in wealth? Despite their quantitative importance, transitory fluctuations in asset values are found to be unrelated to aggregate consumer spending. Instead, aggregate consumption can be well described as a function of the trend components in wealth and income. We find no evidence that consumption adapts with a long lag to fluctuations in wealth. 3. What kinds of shocks govern the dynamic behaviour of consumption, asset wealth and labour income? We characterize three: a permanent income shock that affects consumption, asset wealth and labour earnings without distorting their long-run equilibrium relation; an income redistributive shock that shifts the composition of income between labour and capital; and a discount rate shock that generates transitory variation in asset values.

Wealth effect, cointegration, consumption, asset values

Abstract:
Both textbook economics and common sense teach us that the value of household wealth should be related to consumer spending. At the same time, movements in asset values often seem disassociated with important movements in consumer spending, as episodes such as the 1987 stock market crash and the contraction in equity values that occurred in the fall of 1998 suggest. An important first step in understanding the consumption-wealth linkage is determining how closely the two variables are actually correlated, and whether there exist important movements in asset values that are not associated with changes in consumption. This paper provides evidence that a surprisingly small fraction of the variation in household net worth is related to variation in aggregate consumer spending. We use empirical techniques that allow us to quantify the relative importance of permanent and transitory innovations in the variation of consumer spending and wealth and find that transitory shocks dominate post-war variation in wealth, while permanent shocks dominate variation in aggregate consumption. Although transitory innovations are found to have little influence on consumer spending, they have long-lasting effects on wealth, exhibiting a half-life of a little over two years. The findings suggest that most macro models - which make no allowance for transitory variation in wealth that is orthogonal to consumption - are likely to misstate both the timing and magnitude of the consumption-wealth linkage.

Abstract:
Are there important cyclical fluctuations in bond market premiums and, if so, with what macroeconomic aggregates do these premiums vary? We use the methodology of dynamic factor analysis for large datasets to investigate possible empirical linkages between forecastable variation in excess bond returns and macroeconomic fundamentals. We find that “real” and “inflation” factors have important forecasting power for future excess returns on U.S. government bonds, above and beyond the predictive power contained in forward rates and yield spreads. This behavior is ruled out by commonly employed affine term structure models where the forecastability of bond returns and bond yields is completely summarized by the cross-section of yields or forward rates. An important implication of these findings is that the cyclical behavior of estimated risk premia in both returns and long-term yields depends importantly on whether the information in macroeconomic factors is included in forecasts of excess bond returns. Without the macro factors, risk premia appear virtually acyclical, whereas with the estimated factors risk premia have a marked countercyclical component, consistent with theories that imply investors must be compensated for risks associated with macroeconomic activity.

E0, E4, G10, G12

Abstract:
Empirical evidence suggests that excess bond returns are forecastable by financial indicators such as forward spreads and yield spreads, a violation of the expectations hypothesis based on constant risk premia. But existing evidence does not tie the forecastable variation in excess bond returns to underlying macroeconomic fundamentals, as would be expected if the forecastability were attributable to time variation in risk premia. We use the methodology of dynamic factor analysis for large datasets to investigate possible empirical linkages between forecastable variation in excess bond returns and macroeconomic fundamentals. We find that several common factors estimated from a large dataset on U.S. economic activity have important forecasting power for future excess returns on U.S. government bonds. Following Cochrane and Piazzesi (2005), we also construct single predictor state variables by forming linear combinations of either five or six estimated common factors. The single state variables forecast excess bond returns at maturities from two to five years, and do so virtually as well as an unrestricted regression model that includes each common factor as a separate predictor variable. The linear combinations we form are driven by both "real" and "inflation" macro factors, in addition to financial factors, and contain important information about one year ahead excess bond returns that is not captured by forward spreads, yield spreads, or the principal components of the yield covariance matrix.

Abstract:
Are excess stock market returns predictable over time and, if so, at what horizons and with which economic indicators? Can stock return predictability be explained by changes in stock market volatility? How does the mean return per unit risk change over time? This chapter reviews what is known about the time-series evolution of the risk-return tradeoff for stock market investment, and presents some new empirical evidence using a proxy for the log consumption-aggregate wealth ratio as a predictor of both the mean and volatility of excess stock market returns. We characterize the risk-return tradeoff as the conditional expected excess return on a broad stock market index divided by its conditional standard deviation, a quantity commonly known as the Sharpe ratio. Our own investigation suggests that variation in the equity risk-premium is strongly negatively linked to variation in market volatility, at odds with leading asset pricing models. Since the conditional volatility and conditional mean move in opposite directions, the degree of countercyclicality in the Sharpe ratio that we document here is far more dramatic than that produced by existing equilibrium models of financial market behaviour, which completely miss the sheer magnitude of variation in the price of stock market risk.

Sharpe ratio, expected returns, volatility, consumption

Abstract:
We study the role of information in asset pricing models with long-run cash flow risk. To illustrate the importance of the information structure, we show how the implications of the long run risk paradigm for the cross-sectional properties of stock returns and cash flow duration are affected by information. When investors can fully distinguish short- and long-run consumption risk components of dividend growth innovations (full information), only exposure to long-run consumption risk generates significant risk premia, implying that high return value stocks are long-duration assets, contrary to the historical data. By contrast, when investors observe the change in consumption and dividends each period but not the individual components of that change (limited information), exposure to short-run risk can generate large risk premia, so that high-return value stocks are short-duration assets while low-return growth stocks are long-duration assets, as in the data. We also show that, in order to explain empirical finding that long-horizon equity is less risky than short-horizon equity, the properties of the cash flow model and the values of primitive preference parameters must be quite different from those emphasized in the existing long-run risk literature.

Abstract:
Evidence suggests that expected excess stock market returns vary over time, and that this variation is much larger than that of expected real interest rates. It follows that a large fraction of the movement in the cost of capital in standard investment models must be attributable to movements in equity risk premia. In this Paper we emphasise that such movements in equity risk premia should have implications not merely for investment today, but also for future investment over long horizons. In this case, predictive variables for excess stock returns over long-horizons are also likely to forecast long-horizon fluctuations in the growth of marginal Q, and therefore investment. We test this implication directly by performing long-horizon forecasting regressions of aggregate investment growth using a variety of predictive variables shown elsewhere to have forecasting power for excess stock market returns.

Q-Theory, investment, risk premia

Abstract:
This paper studies the ability of a general class of habit-based asset pricing models to match the conditional moment restrictions implied by asset pricing theory. We treat the functional form of the habit as unknown, and to estimate it along with the rest of the model`s finite dimensional parameters. Using quarterly data on consumption growth, assets returns and instruments, our empirical results indicate that the estimated habit function is nonlinear, the habit formation is better described as internal rather than external, and the estimated time-preference parameter and the power utility parameter are sensible. In addition, the estimated habit function generates a positive stochastic discount factor (SDF) proxy and performs well in explaining cross-sectional stock return data . We find that an internal habit SDF proxy can explain a cross-section of size and book-market sorted portfolio equity returns better than (i) the Fama and French (1993) three-factor model, (ii) Lettau and Ludvigson (2001) scaled consumption CAPM model, (iii) an external habit SDF proxy, (iv) the classic CAPM, and (v) the classic consumption CAPM.

Abstract:
We study the role of information in asset pricing models with long-run cash flow risk. To illustrate the importance of the information structure, we show how the implications of the long-run risk paradigm for the cross-sectional properties of stock returns and cash flow duration are affected by information. When investors can fully distinguish short- and long-run consumption risk components of dividend growth innovations (full information), only exposure to long-run consumption risk generates significant risk premia, implying that high-return value stocks are long-duration assets, contrary to the historical data. By contrast, when investors observe the change in consumption and dividends each period but not the individual components of that change (limited information), exposure to short-run risk can generate large risk premia, so that high-return value stocks are short-duration assets while low-return growth stocks are long-duration assets, as in the data. We also show that, in order to explain empirical finding that long-horizon equity is less risky than short-horizon equity, the properties of the cash flow model and the values of primitive preference parameters must be quite different from those emphasized in the existing long-run risk literature.

Abstract:
A wide range of empirical applications rely on linear approximations to dynamic Euler equations. Among the most notable of these is the large and growing literature on precautionary saving that examines how consumption growth and saving behavior are affected by uncertainty and prudence. Linear approximations to Euler equations imply a linear relationship between expected consumption growth and uncertainty in consumption growth, with a slope coefficient that is a function of the coefficient of relative prudence. This literature has produced puzzling results: Estimates of the coefficient of relative prudence (and the coefficient of relative risk aversion) from regressions of consumption growth on uncertainty in consumption growth imply estimates of prudence and risk aversion that are unrealistically low. Using numerical solutions to a fairly standard intertemporal optimization problem, our results show that the actual relationship between expected consumption growth and uncertainty in consumption growth differs substantially from the relationship implied by a linear approximation. We also present Monte Carlo evidence that shows that the instrumental variables methods commonly used to estimate the parameters correct some, but not all, of the approximation bias.

Abstract:
A summary of the floor discussion following the conference's first session.

New York City, New York City economy

Abstract:
This paper uses the factor augmented regression framework to analyze the relation between bond excess returns and the macro economy. Using a panel of 131 monthly macroeconomic time series for the sample 1964:1-2007:12, we estimate 8 static factors by the method of asymptotic principal components. We also use Gibb sampling to estimate dynamic factors from the 131 series reorganized into 8 blocks. Regardless of how the factors are estimated, macroeconomic factors are found to have statistically significant predictive power for excess bond returns. We show how a bias correction to the parameter estimates of factor augmented regressions can be obtained. This bias is numerically trivial in our application. The predictive power of real activity for excess bond returns is robust even after accounting for finite sample inference problems. Forecasts of excess bond returns (or bond risk premia) are countercyclical. This implies that investors are compensated for risks associated with recessions.

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Abstract:
This paper explores the ability of conditional versions of the CAPM and the consumption CAPM - jointly the (C)CAPM - to explain the cross section of average stock returns. Central to our approach is the use of the log consumption-wealth ratio as a conditioning variable. We demonstrate that such conditional models perform far better than unconditional specifications and about as well as the Fama-French three-factor model on portfolios sorted by size and book-to-market characteristics. The conditional consumption CAPM can account for the difference in returns between low-book-to-market and high-book-to-market portfolios and exhibits little evidence of residual size or book-to-market effects.

Abstract:
This paper studies the optimal consumption behavior of individuals who face borrowing limitations that vary stochastically with their income. This framework is motivated by new empirical evidence that I document in U.S. aggregate data: predictable growth in consumer credit is significantly related to consumption growth, a finding that is inconsistent with existing models of consumer behavior. The time-varying liquidity constraint model considered here correctly predicts two key properties of the U.S. aggregate data: the correlation of consumption growth with predictable credit growth documented in this paper, and the well known correlation between consumption growth and predictable income growth that has been documented extensively elsewhere.

Abstract:
In response to tight money, both consumer loans and consumption fall. I ask whether there is any causality running from loans to consumption by focusing on how the composition of automobile finance between bank and nonbank sources of credit changes in response to unanticipated innovations in monetary policy. The results indicate that contractionary monetary policy produces a statistically significant reduction in the relative supply of bank consumer loans, which in turn produces a decline in real consumption. The evidence therefore supports the existence of a credit channel of monetary transmission to aggregate consumption. Moreover, the nature of automobile finance is uniquely suited to identifying which of two possible sub-channels of the broader credit channel is relatively more important, and suggests the results are more likely consistent with a bank lending channel than with a pure balance sheet channel. However, the findings also indicate that the quantitative effects of the lending channel on the aggregate economy, though precisely estimated, may be quite small.