Cyclical Consumption and Expected Returns: New Evidence - How Long Does it Take to Form the Habit in Habit Model?

30 Pages Posted: 26 Nov 2019

See all articles by Yulong Sun

Yulong Sun

Bocconi University, Department of Finance

Date Written: September 1, 2019

Abstract

Atanasov, Møller, and Priestley (2019) find that cyclical consumption at 5-7 year frequency can predict (excess) returns at market level and they argue that low-frequency fluctuations in consumption capture slow-moving counter-cyclical variations in expected returns. Based on cross-sectional evidence, I find that their results are mainly driven by the large-capitalization stocks and cannot be extended to other sorted portfolios. Meanwhile, all firms' returns can be predicted by cyclical consumption at 1-2 year frequency and it suggests cyclical consumption may capture the risk premia at shorter business cycle frequency. I also find cyclical consumption growth is persistent and the persistence increases with time horizon and the future dividend-price ratio can be predicted by cyclical consumption. To rationalize the stylized facts, I modify the Campbell-Cochrane habit model by allowing persistent consumption growth and finite-horizon habit formation. The modified model can reproduce the inverse relation between cyclical consumption and future expected stock returns, consistent with empirical findings.

Keywords: Cyclical consumption growth, Habit formation and habit model, Return predictability

JEL Classification: G10

Suggested Citation

Sun, Yulong, Cyclical Consumption and Expected Returns: New Evidence - How Long Does it Take to Form the Habit in Habit Model? (September 1, 2019). Available at SSRN: https://ssrn.com/abstract=3486543 or http://dx.doi.org/10.2139/ssrn.3486543

Yulong Sun (Contact Author)

Bocconi University, Department of Finance

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