Production, Consumption, and Time Varying Expected Returns
58 Pages Posted: 15 Dec 2020 Last revised: 8 Feb 2021
Date Written: February 8, 2021
This paper develops an empirical test of the q-theory production based asset pricing model. In general equilibrium, with habit utility and adjustment costs of investment, it must be the case that when the consumption surplus predicts stock returns corresponding investment patterns must predict investment returns to the same extent. The no arbitrage condition also implies investment patterns must predict stock returns in the same way as the consumption surplus. Using this insight, we find strong empirical support for the production based model without encountering the difficulties of calculating investment returns. Consequently, previous rejections of the model most likely stem from the failure of one or more of the many assumptions that are needed to construct investment returns.
Keywords: return predictability, Investment returns, production based asset pricing, consumption fluctuations, investment fluctuations
JEL Classification: G10, G12, G17
Suggested Citation: Suggested Citation