TAILIEUCHUNG - Consumption, Aggregate Wealth, and Expected Stock Returns

Second, the model is consistent with multifactor volatility models or CGARCH e¤ects. Both endowment risk and sentiment risk are associated with instantaneous shocks associated with the idiosyncratic risk embedded in the Brownian motions present in the investors endowments. In contrast, solvency risk is associated with the binding of solvency constraints, and therefore it occurs at a lower frequency. Because the shadow price of solvency constraints alternates behavior between endogenous regimes of binding constraints and endogenous regimes of non-binding constraints, solvency risk clusters with a lower decay rate and exhibits a transient persistence. To my knowledge, this is the rst paper which nds a theoretical foundation for the. | THE JOURNAL OF FINANCE VOL. LVI NO. 3 JUNE 2001 Consumption Aggregate Wealth and Expected Stock Returns MARTIN LETTAU and SYDNEY LUDVIGSON ABSTRACT This paper studies the role of fluctuations in the aggregate consumption wealth ratio for predicting stock returns. Using . quarterly stock market data we find that these f luctuations in the consumption wealth ratio 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 dividend payout ratio and several other popular forecasting variables. Why should the consumption wealth ratio forecast asset returns We show that a wide class of optimal models of consumer behavior imply that the log consumption aggregate wealth human capital plus asset holdings ratio summarizes expected returns on aggregate wealth or the market portfolio. Although this ratio is not observable we provide assumptions under which its important predictive components for future asset returns may be expressed in terms of observable variables namely in terms of consumption asset holdings 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. Understanding the empirical linkages between macroeconomic variables and financial markets has long been a goal of financial economics. One reason for the interest in these linkages is that expected excess returns on common stocks appear to vary with the business cycle. This evidence suggests that stock returns should be forecastable by business cycle variables at cyclical frequencies. Indeed the forecastability of stock returns is well documented. Financial indicators such as the ratios of price to dividends price to earnings or dividends to earnings have predictive power for excess returns over a .

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