This paper studies the role of fluctuations in the aggregate consumption–wealth ratio for predicting stock returns. Using U.S. quarterly stock market data, we find that these fluctuations 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

This paper surveys the field of asset pricing. The emphasis is on the interplay between theory and empirical work and on the trade-off between risk and return. Modern research seeks to understand the behavior of the stochastic discount factor ~SDF! that prices all assets in the economy. The behavior of the term structure of real interest rates restricts the conditional mean of the SDF, whereas patterns of risk premia restrict its conditional volatility and factor structure. Stylized facts about interest rates, aggregate stock prices, and cross-sectional patterns in stock returns have stimulated new research on optimal portfolio choice, intertemporal equilibrium models, and behavioral finance. This paper surveys the field of asset pricing. The emphasis is on the interplay between theory and empirical work. Theorists develop models with testable predictions; empirical researchers document “puzzles”—stylized facts that fail to fit established theories—and this stimulates the development of new theories. Such a process is part of the normal development of any science. Asset pricing, like the rest of economics, faces the special challenge that data are generated naturally rather than experimentally, and so researchers cannot control the quantity of data or the random shocks that affect the data. A particularly interesting characteristic of the asset pricing field is that these random shocks are also the subject matter of the theory. As Campbell, Lo, and MacKinlay ~1997, Chap. 1, p. 3! put it: What distinguishes financial economics is the central role that uncertainty plays in both financial theory and its empirical implementation. The starting point for every financial model is the uncertainty facing investors, and the substance of every financial model involves the impact of uncertainty on the behavior of investors and, ultimately, on mar-* Department of Economics, Harvard University, Cambridge, Massachusetts

We show that the external habit-formation model economy of Campbell and Cochrane ~1999! can explain why the Capital Asset Pricing Model ~CAPM! and its extensions are better approximate asset pricing models than is the standard consumptionbased model. The model economy produces time-varying expected returns, tracked by the dividend--price ratio. Portfolio-based models capture some of this variation in state variables, which a state-independent function of consumption cannot capture. Therefore, though the consumption-based model and CAPM are both perfect conditional asset pricing models, the portfolio-based models are better approximate unconditional asset pricing models. THE DEVELOPMENT OF CONSUMPTION-BASED ASSET PRICING THEORY ranks as one of the major advances in financial economics during the last two decades. The classic papers of Lucas ~1978!, Breeden ~1979!, Grossman and Shiller ~1981!, and Hansen and Singleton ~1982, 1983! show how a simple relation between consumption ...

This is the first study that computes default measures for individual firms using Merton’s (1974) option pricing model, to assess the effect that default risk has on equity returns. We find that equally-weighted portfolios of stocks with high default probability earn significantly higher returns than equally-weighted portfolio of stocks with low default probability. In addition, both the size and book-to-market effects are present only within the portfolio of stocks with the highest default probabilities. Once stocks with the 30 % highest default probabilities are excluded from the sample, both size and B/M effects disappear. We also find that default risk is priced and can explain part of the cross-sectional variation in returns. The Fama-French factors SMB and HML, and particularly SMB, contain some default-related information, although it appears that this information is not the driving force behind the success of the Fama-French model. Keywords: default risk, equity returns, Merton’s (1974) model, size and book-to-market. JEL classification: G33, G12 1

We examine how investor sentiment affects the cross-section of stock returns. Theory predicts that a broad wave of sentiment will disproportionately affect stocks whose valuations are highly subjective and are difficult to arbitrage. We test this prediction by studying how the cross-section of subsequent stock returns varies with proxies for beginning-of-period investor sentiment. When sentiment is low, subsequent returns are relatively high on smaller stocks, high volatility stocks, unprofitable stocks, non-dividend-paying stocks, extreme-growth stocks, and distressed stocks, consistent with an initial underpricing of these stocks. When sentiment is high, on the other hand, these patterns attenuate or fully reverse. The results are consistent with predictions and appear unlikely to reflect an alternative explanation based on compensation for systematic risk.

In a model with housing collateral, the ratio of housing wealth to human wealth shifts the conditional distribution of asset prices and consumption growth. A decrease in house prices reduces the collateral value of housing, increases household exposure to idiosyncratic risk, and increases the conditional market price of risk. Using aggregate data for the US, we find that a decrease in the ratio of housing wealth to human wealth predicts higher returns on stocks. Conditional on this ratio, the covariance of returns with aggregate risk factors explains eighty percent of the cross-sectional variation in annual size and book-to-market portfolio returns. 1

Abstract not found

The paper has also benefited from the comments of the participants at the Chicago Quantitative Alliance spring meeting, Federal Reserve Bank of New York finance workshop, Harvard University Department of Economics finance seminar, MIT Sloan School of Management finance brown-bag lunch and finance seminar, NBER Behavioral Finance working group meeting, and Stanford Business School finance seminar. Errors and omissions remain our responsibility. The views expressed herein are those of the authors and not necessarily those of the National Bureau of Economic Research.

Aggregate consumption growth risk explains why low interest rate currencies do not appreciate as much as the interest rate differential and why high interest rate currencies do not depreciate as much as the interest rate differential. Domestic investors earn negative excess returns on low interest rate currency portfolios and positive excess returns on high interest rate currency portfolios. Because high interest rate currencies depreciate on average when domestic consumption growth is low and low interest rate currencies appreciate under the same conditions, low interest rate currencies provide domestic investors with a hedge against domestic aggregate consumption growth risk.

This paper investigates the importance of idiosyncratic consumption risk for the cross-sectional variation in average returns on stocks and bonds. If idiosyncratic consumption risk is not priced, the only pricing factor in a multiperiod economy is the rate of aggregate consumption growth. We o®er evidence that the cross-sectional variance of consumption growth is also a priced factor. This demonstrates that consumers are not fully insured against idiosyncratic consumption risk, and that asset returns re°ect their attempts to reduce their exposure to this risk. We ¯nd that over the sample period the resulting two-factor pricing model has lower Hansen-Jagannathan distances than the CAPM and the Fama-French three-factor model. Moreover, in the presence of the market factor and the size and book-to-market factors, the two consumption based factors retain explanatory power. Together with the results of Lettau and Ludvigson (2000), these ¯ndings indicate that consumption-based asset pricing is relevant for explaining the cross-section of asset returns.