Habit formation, surplus consumption and return predictability: International evidence

Tom Engsted, Stuart Hyde and Stig V. Møller

Journal of International Money and Finance, 2010, vol. 29, issue 7, 1237-1255

Abstract: On an international post World War II dataset, we use an iterated GMM procedure to estimate and test the Campbell and Cochrane (1999, By force of habit: a consumption-based explanation of aggregate stock market behavior. Journal of Political Economy 107, 205-251.) habit formation model with a time-varying risk-free rate. In addition, we analyze the predictive power of the surplus consumption ratio for future stock and bond returns. We find that, although there are important cross-country differences and economically significant pricing errors, for the majority of countries in our sample the model gets empirical support in a variety of different dimensions, including reasonable estimates of risk-free rates. Further, for the majority of countries the surplus consumption ratio captures time-variation in expected returns. Together with the price-dividend ratio, the surplus consumption ratio contains significant information about future stock returns, also during the 1990s. In addition, in most countries the surplus consumption ratio is also a powerful predictor of future bond returns. Thus, the surplus consumption ratio captures time-varying expected returns in both stock and bond markets.

Keywords: Habit; formation; Campbell-Cochrane; model; Surplus; consumption; ratio; GMM; estimation; Pricing; errors; Return; predictability (search for similar items in EconPapers)
Date: 2010
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Citations: View citations in EconPapers (12)

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Working Paper: Habit Formation, Surplus Consumption and Return Predictability: International Evidence (2007)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jimfin:v:29:y:2010:i:7:p:1237-1255

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