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Consumption, Aggregate Wealth, and Expected Stock Returns
 THE JOURNAL OF FINANCE • VOL. LVI, NO. 3 • JUNE 2001
, 2001
"... 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 Treas ..."
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Cited by 150 (18 self)
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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
Asset pricing at the millennium
 Journal of Finance
"... This paper surveys the field of asset pricing. The emphasis is on the interplay between theory and empirical work and on the tradeoff 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 ..."
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Cited by 123 (3 self)
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This paper surveys the field of asset pricing. The emphasis is on the interplay between theory and empirical work and on the tradeoff 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 crosssectional 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
Investor Sentiment and the CrossSection of Stock Returns
, 2003
"... We examine how investor sentiment affects the crosssection 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 crosssection of subse ..."
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Cited by 100 (8 self)
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We examine how investor sentiment affects the crosssection 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 crosssection of subsequent stock returns varies with proxies for beginningofperiod investor sentiment. When sentiment is low, subsequent returns are relatively high on smaller stocks, high volatility stocks, unprofitable stocks, nondividendpaying stocks, extremegrowth 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.
Default risk and equity returns
 Journal of Finance
, 2004
"... 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 equallyweighted portfolios of stocks with high default probability earn significantly higher returns tha ..."
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Cited by 62 (0 self)
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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 equallyweighted portfolios of stocks with high default probability earn significantly higher returns than equallyweighted portfolio of stocks with low default probability. In addition, both the size and booktomarket 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 crosssectional variation in returns. The FamaFrench factors SMB and HML, and particularly SMB, contain some defaultrelated information, although it appears that this information is not the driving force behind the success of the FamaFrench model. Keywords: default risk, equity returns, Merton’s (1974) model, size and booktomarket. JEL classification: G33, G12 1
Housing collateral, consumption insurance, and risk premia, Working paper
, 2002
"... 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 condit ..."
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Cited by 58 (2 self)
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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 crosssectional variation in annual size and booktomarket portfolio returns. 1
Explaining the Poor Performance of Consumptionbased Asset Pricing Models
 Journal of Finance
, 2000
"... We show that the external habitformation 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 timevarying expect ..."
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Cited by 54 (4 self)
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We show that the external habitformation 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 timevarying expected returns, tracked by the dividendprice ratio. Portfoliobased models capture some of this variation in state variables, which a stateindependent function of consumption cannot capture. Therefore, though the consumptionbased model and CAPM are both perfect conditional asset pricing models, the portfoliobased models are better approximate unconditional asset pricing models. THE DEVELOPMENT OF CONSUMPTIONBASED 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 ...
Why is longhorizon equity less risky? A durationbased explanation of the value premium, NBER working paper
, 2005
"... We propose a dynamic riskbased model that captures the value premium. Firms are modeled as longlived assets distinguished by the timing of cash flows. The stochastic discount factor is specified so that shocks to aggregate dividends are priced, but shocks to the discount rate are not. The model im ..."
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Cited by 50 (10 self)
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We propose a dynamic riskbased model that captures the value premium. Firms are modeled as longlived assets distinguished by the timing of cash flows. The stochastic discount factor is specified so that shocks to aggregate dividends are priced, but shocks to the discount rate are not. The model implies that growth firms covary more with the discount rate than do value firms, which covary more with cash flows. When calibrated to explain aggregate stock market behavior, the model accounts for the observed value premium, the high Sharpe ratios on value firms, and the poor performance of the CAPM. THIS PAPER PROPOSES A DYNAMIC RISKBASED MODEL that captures both the high expected returns on value stocks relative to growth stocks, and the failure of the capital asset pricing model to explain these expected returns. The value premium, first noted by Graham and Dodd (1934), is the finding that assets with a high ratio of price to fundamentals (growth stocks) have low expected returns relative to assets with a low ratio of price to fundamentals (value stocks). This
Equilibrium Cross Section of Returns
"... We construct a dynamic general equilibrium production economy to explicitly link expected stock returns to firm characteristics such as firm size and the booktomarket ratio. Stock returns in the model are completely characterized by a conditional capital asset pricing model (CAPM). Size and bookt ..."
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Cited by 50 (11 self)
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We construct a dynamic general equilibrium production economy to explicitly link expected stock returns to firm characteristics such as firm size and the booktomarket ratio. Stock returns in the model are completely characterized by a conditional capital asset pricing model (CAPM). Size and booktomarket are correlated with the true conditional market beta and therefore appear to predict stock returns. The crosssectional relations between firm characteristics and returns can subsist even after one controls for typical empirical estimates of beta. These findings suggest that the empirical success of size and booktomarket can be consistent with a singlefactor conditional CAPM model. We gratefully acknowledge the helpful comments of Andy Abel, Jonathan Berk, Michael
The Maturity of Debt Issues and Predictable Variation in Bond Returns
 JOURNAL OF FINANCIAL ECONOMICS
, 2002
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Consumption, dividends, and the crosssection of equity returns
, 2002
"... A central economic idea is that an asset’s risk premium is determined by its ability to insure against fluctuations in consumption (i.e., by the consumption beta). Crosssectional differences in consumption betas mirror differences in the exposure of the asset’s dividends to aggregate consumption, an ..."
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Cited by 42 (9 self)
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A central economic idea is that an asset’s risk premium is determined by its ability to insure against fluctuations in consumption (i.e., by the consumption beta). Crosssectional differences in consumption betas mirror differences in the exposure of the asset’s dividends to aggregate consumption, an implication of many general equilibrium models. Hence, crosssectional differences in the exposure of dividends to consumption may provide valuable information regarding the crosssectional dispersion in risk premia. We measure the exposure of dividends to consumption (labeled as consumption leverage) by the covariance of expost dividend growth rates with the expected consumption growth rate, and alternatively by relying on stochastic cointegration between dividends and consumption. Crosssectional differences in this consumption leverage parameter can explain about 50 % of the variation in risk premia across 30 portfolios— which include 10 momentum, 10 size, and 10 booktomarket sorted portfolios. The consumption leverage model can justify much of the observed value, momentum, and size risk premium spreads. For this asset menu, alternative models proposed in the literature