57 Pages Posted: 11 Aug 1999
Date Written: June 1999
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.
JEL Classification: G10, E21
Suggested Citation: Suggested Citation
Lettau, Martin and Ludvigson, Sydney C., Consumption, Aggregate Wealth and Expected Stock Returns (June 1999). FRB of New York Staff Report No. 77. Available at SSRN: https://ssrn.com/abstract=169791 or http://dx.doi.org/10.2139/ssrn.169791
By Owen Lamont