Deep Habits and the Cross Section of Expected Returns

Abstract:     
I study the cross-section of expected returns in a general equilibrium framework in which agents form habits over individual varieties of goods as opposed to over a composite consumption good. Goods are produced by monopolistically competitive firms whose income and price elasticities of demand depend on the habit formation of the consumers. Firms who produce goods with a low consumption surplus ratio earn low expected returns because their income and price elasticities of demand are low. Under the assumption that firms face adjustment costs to their input factors, such firms also temporarily charge higher prices for their products. As such, the model generates a negative relationship between the expected return on a firm's stock and (changes in) the selling price of its product. I analyze this relationship empirically by sorting firms into portfolios based on recent price changes, as measured by the industry level producer price index. This sorting generates a statistically significant annual return spread of 6 percent that cannot be explained by the unconditional CAPM nor by the four-factor model.

Keywords: Habit formation, Cross Section, Expected Returns, Markups

Working Paper Series