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Consumption growth predictability and asset prices

Tai-Yong Roh, Changjun Lee and Byoung-Kyu Min

Journal of Empirical Finance, 2019, vol. 51, issue C, 95-118

Abstract: We derive and test a consumption-based intertemporal asset pricing model in which an asset earns a risk premium if it performs poorly when expected future consumption growth deteriorates. The predictability of consumption growth combined with the recursive preference delivers news about future consumption growth an additional risk factor, in addition to news about current consumption growth. We model the consumption growth dynamics using a vector autoregressive (VAR) structure with a set of instrumental variables commonly used for forecasting future economic growth. Our VAR estimation provides strong empirical support for future consumption growth predictability. The cross-sectional test shows that the model explains reasonably well the dispersion in average excess returns of 25 portfolios sorted on size and book-to-market, as well as 25 portfolios sorted on size and long-term return reversal. Growth stocks and long-term winners underperform value stocks and long-term losers, respectively, because growth stocks and long-term winners hedge adverse changes in the future consumption growth opportunities.

Keywords: Consumption-based asset pricing model; Consumption growth predictability; Recursive preference; Value premium; Long-term return reversal (search for similar items in EconPapers)
JEL-codes: E21 E44 G12 (search for similar items in EconPapers)
Date: 2019
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Journal of Empirical Finance is currently edited by R. T. Baillie, F. C. Palm, Th. J. Vermaelen and C. C. P. Wolff

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