Habit Formation, Surplus Consumption and Return Predictability: International Evidence

Abstract:     
On an international post World War II dataset, we use an iterated GMM procedure to estimate and test the Campbell-Cochrane (1999) habit formation model. In addition, we analyze the predictive power of the surplus consumption ratio for future asset returns. We find that, although there are important cross-country differences, for the majority of countries in our sample the model gets empirical support in a variety of diffrent dimensions, including reasonable estimates of risk-free rates, and the model dominates the time-separable power utility model in terms of pricing errors. Further, for the majority of countries the surplus consumption ratio captures time-variation in expected returns. Together with the price-dividend ratio, the surplus consumption ratio contains significant information about future stock returns, also during the 1990s. Finally, in most countries the surplus consumption ratio is also a powerful predictor of future bond returns.

Keywords: Habit formation, Campbell-Cochrane model, surplus consumption ratio, GMM estimation, pricing errors, return predictability

JEL Classifications: E21, G12, G15

Working Paper Series