Consumption Disconnect Redux

Alessandro Melone
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Alessandro Melone: Ohio State U

Working Paper Series from Ohio State University, Charles A. Dice Center for Research in Financial Economics

Abstract: Several papers show that the apparent disconnect between stock returns and consumption growth is due to mismeasurement in standard consumption data, and propose to use new consumption measures instead. This paper finds that standard consumption is valuable for asset pricing if one focuses on consumption levels rather than growth. I analytically show that, when consumption levels contain a permanent and a transitory component, the latter--dubbed the consumption gap--should predict returns if the time series consumption-based model is valid. A simulated economy demonstrates that the relationship between expected returns and the consumption gap is robust to mismeasurement of consumption. Empirically, the consumption gap forecasts stock returns in-and out-of-sample at horizons from one quarter to five years, even after controlling for alternative popular predictors. This predictability generates significant economic value from the perspective of a mean variance investor. Finally, I use the cross-section of stocks to construct a heuristic stochastic discount factor that displays properties consistent with benchmark macro-finance models.

JEL-codes: C22 E32 E44 G12 (search for similar items in EconPapers)
Date: 2023-06
New Economics Papers: this item is included in nep-fdg
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Persistent link: https://EconPapers.repec.org/RePEc:ecl:ohidic:2023-18

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