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Consumption, Aggregate Wealth and Expected Stock Returns: An FCVAR Approach

Ricardo Quineche

Journal of Time Series Econometrics, 2021, vol. 13, issue 1, 21-42

Abstract: In their seminal work, Lettau, M., and S. Ludvigson, 2001, “Consumption, Aggregate Wealth, and Expected Stock Returns.” The Journal of Finance 56 (3): 815–49., demonstrated that there exists a long-run relationship between consumption, asset holdings, and labor income. They denoted this relationship as cay and showed it to be quite successful in predicting the behavior of real stock returns. Their estimation procedure assumes that consumption, asset wealth, and labor income are first-order integrated (I(1), nonstationary) and that their linear combination forms a zero-order integrated (I(0), stationary) series. This paper proposes a more general framework in the estimation of the cay model by allowing both the series and the long-run equilibrium to be fractionally integrated. We use the recently developed Fractionally Cointegrated VAR (FCVAR) approach to estimate the cay model. Results show that: (i) the series are nonstationary but mean-reverting processes, (ii) there exists a long-run equilibrium between consumption, asset wealth, and labor income, (iii) this long-run relationship is a stationary fractionally integrated process, and (iv) the estimated cay using the FCVAR approach shows the same desirable forecasting properties as its predecessor.

Keywords: cay; cointegration; fractional cointegration; fractional integration; vector autoregressive model; likelihood inference (search for similar items in EconPapers)
Date: 2021
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DOI: 10.1515/jtse-2020-0029

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