External Habit and the Cyclicality of Expected Stock Returns

Abstract

We estimate an equilibrium asset pricing model in which agents' preferences have an unobserved external habit using the efficient method of moments (EMM). Given the estimated structural parameters we examine the cyclical behavior of expected stock returns in the model. We find that the estimated structural parameters imply countercyclical expected stock returns as documented in existing empirical studies. The model, however, is still rejected at the one percent level. Detailed examination of the moment conditions in our estimation indicates that the model performs reasonably well in matching the mean of the stock returns, but it fails to capture the higher order moments such as variance, skewness and kurtosis.

JEL Classification: G12