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Expectations, Shocks, and Asset Returns

Ricardo M. Sousa

University of Minho; Economic Policies Research Unit (NIPE); London School of Economics & Political Science (LSE) - Financial Markets Group; London School of Economics

October 30, 2007

University of Minho, NIPE Working Paper No. 29/2007

I use the consumer's budget constraint to derive a relationship between stock market returns, the residuals of the trend relationship among consumption, aggregate wealth, and labour income, cay, and three major sources of risk: future changes in the housing consumption share, cr, future labour income growth, lr, and future consumption growth, lrc.

Using a VAR, I compute measures of expected and unexpected long-run changes of the major determinants of asset returns and find that: (i) cay, cday, expected lr, cr, lrc and expected long-run changes in ex-ante real returns, lrret, strongly forecast future asset returns; (ii) unexpected lrc and unexpected lrret contain some predictive power for asset returns; (iii) unexpected lr and unexpected cr do not predict future asset returns.

One can, therefore, use the intertemporal budget constraint and the forecasting properties of an informative VAR to generate the predictability of many economically motivated variables developed in the literature on asset pricing. The framework presented is sufficiently flexible to accommodate the implications of a wide class of optimal models of consumer behaviour without imposing a functional form on preferences.

Number of Pages in PDF File: 29

Keywords: Expectations, shocks, asset returns, wealth, income, consumption, housing share

JEL Classification: E21, E44, D12

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Date posted: November 20, 2007 ; Last revised: January 29, 2009

Suggested Citation

Sousa, Ricardo M., Expectations, Shocks, and Asset Returns (October 30, 2007). University of Minho, NIPE Working Paper No. 29/2007. Available at SSRN: http://ssrn.com/abstract=1030852 or http://dx.doi.org/10.2139/ssrn.1030852

Contact Information

Ricardo Magalhaes Sousa (Contact Author)
University of Minho ( email )
4710-057 Braga
+351253604584 (Phone)
+351253676375 (Fax)
HOME PAGE: http://www.eeg.uminho.pt/economia/rjsousa
Economic Policies Research Unit (NIPE) ( email )
Campus de Gualtar
Braga, 4710-057
+351253604584 (Phone)
+351253676375 (Fax)
HOME PAGE: http://www.eeg.uminho.pt/economia/rjsousa
London School of Economics & Political Science (LSE) - Financial Markets Group ( email )
Houghton Street
London WC2A 2AE
United Kingdom
London School of Economics ( email )
Houghton Street
London, WC2A 2AE
United Kingdom
HOME PAGE: http://econ.lse.ac.uk
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