Expectations, Shocks, and Asset Returns

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

29 Pages Posted: 20 Nov 2007 Last revised: 29 Jan 2009

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

Date Written: October 30, 2007

Abstract

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.

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

JEL Classification: E21, E44, D12

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: https://ssrn.com/abstract=1030852 or http://dx.doi.org/10.2139/ssrn.1030852

Ricardo Magalhaes Sousa (Contact Author)

University of Minho ( email )

Campus Gualtar
Braga, 4710-057
Portugal
+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
Portugal
+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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