Consumption , Aggregate Wealth , and Expected Stock Returns

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 that deviations from this shared trend summarize agents' expectations of future returns on the market portfolio. UNDERSTANDING THE EMPIRICAL LINKAGES between macroeconomic variables and financial markets has long been a goal of financial economics. One reason for the interest in these linkages is that expected excess returns on common stocks appear to vary with the business cycle. This evidence suggests that stock returns should be forecastable by business cycle variables at cyclical frequencies. Indeed, the forecastability of stock returns is well documented. Financial indicators such as the ratios of price to dividends, price to earnings, or dividends to earnings have predictive power for excess returns over a Treasury-bill rate. These financial variables, however, have been most successful at predicting returns over long horizons. Over horizons spanning the " Lettau and Ludvigson are at the Research Department, Federal Reserve Bank of New York. The authors are grateful to Gregory Bauer, John Y. Campbell, Steve Cecchetti, Todd Clark, Michael Cooper, Wayne Ferson, Kenneth French, Owen Lamont, James Stock, Kenneth West, an anonymous referee, Rick Green (the editor), and to seminar participants at the NBER Asset Pricing Meeting May 1999, the NBER Summer Institute July 2000, the CEPR European Summer Symposium in Finance July 1999, the University of Amsterdam, the University of Bielefeld, Hunter College, Indiana University, Northwestern University, the University of Rochester, and the New York Federal Reserve for helpful comments. Jeffrey Brown and Claire Liou provided excellent research assistance. The views expressed are those of the authors and do not necessarily reflect those of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors. The Journal o f Finance length of a typical business cycle, stock returns have typically been found to be only weakly forecastab1e.l Moreover, traditional macroeconomic variables have proven especially dismal as predictive variables. The question of whether expected returns vary at cyclical frequencies and with macroeconomic variables is also pertinent to the debate over why excess returns are predictable. One possibility is that financial markets are inefficient. Alternatively, predictable variation in returns could simply reflect the rational response of agents to time-varying investment opportunities, possibly driven by cyclical variation in risk aversion (e.g., Sundaresan (1989), Constantinides (1990), Campbell and Cochrane (1999)) or in the joint distribution of consumption and asset returns. If these rational explanations are correct, it is reasonable to expect that key macroeconomic variables should perform an important function in forecasting excess stock returns. As yet, however, there is little empirical evidence that real macroeconomic variables perform such a function. This paper adopts a new approach to investigating the linkages between macroeconomics and financial markets. We begin by noting that aggregate consumption, asset holdings, and labor income share a common long-term trend, but may deviate substantially from one another in the short run. We study the role of these transitory deviations from the common trend in consumption, asset holdings, and labor income for predicting stock market fluctuations. Our results show that these "trend deviations" are a strong univariate predictor of both raw stock returns and excess stock returns over a Treasury bill rate, and can account for a substantial fraction of the variation in future returns. This variable provides information about future stock returns that is not captured by lagged values of other popular forecasting variables, and displays its greatest predictive power for returns over business cycle frequencies, those ranging from one to five quarters. In addition, we find that observations on this variable would have improved out-of-sample forecasts of excess stock returns in postwar data relative to a variety of alternative forecasting models. These results occur despite the fact that the individual growth rates of consumption, labor income, and wealth, like other macroeconomic variables, bear little relationship to future stock returns. Why should deviations from the common long-term trend in consumption, asset wealth, and labor income forecast asset returns? We show that this feature of the data may arise as an implication of a wide range of forwardlooking models of investor behavior where consumption is a function of aggregate wealth (the "market" portfolio), defined as the sum of human and asset wealth. To make the framework tractable, we employ a log-linear approximation of the intertemporal budget constraint. For a wide class of prefOne exception to this is a study by Campbell (1987) which finds that Treasury bill rates and several measures of the term spread can explain a substantial fraction of the variation in next month's excess stock return. We also confirm in our extended sample that a stochastically detrended short rate has modest forecasting power for returns a t business cycle frequencies. Consumption, Aggregate Wealth, and Expected Stock Returns 817 erences, the log consumption-aggregate wealth ratio predicts asset returns because it is a function of expected future returns on the market portfolio. This result has been noted previously by Campbell and Mankiw (1989) and is the starting point of our theoretical framework. There are two important obstacles that must be overcome before the log consumption-aggregate wealth ratio can be empirically linked with future asset returns. The most immediate is that aggregate wealth-specifically the human capital component of it-is unobservable. This paper argues that the important predictive components of the consumption-aggregate wealth ratio for future market returns may be expressed in terms of observable variables, namely in terms of consumption, asset holdings, and current labor income. The model we investigate implies that the log of consumption, labor income, and asset holdings share a common stochastic trend. They are cointegrated. The parameters of this shared trend are the average shares of human capital and asset wealth in aggregate wealth. If expected consumption growth is not too volatile, stationary deviations from the shared trend among these three variables produce movements in the consumption-aggregate wealth ratio and predict future asset returns. This follows from the fact that the consumption-aggregate wealth ratio summarizes agents' expectations of future returns on the market portfolio. Accordingly, deviations from the shared trend will forecast returns to asset holdings, as long as the expected return to human capital is not too volatile. A remaining obstacle to using deviations in the common trend among consumption, labor income, and asset wealth as a forecasting variable is that the parameters of this shared trend are unobservable and must be estimated. In ordinary empirical applications this estimation is problematic due to the presence of endogenous regressors. In our application, however, consumption, labor income, and asset wealth are cointegrated. We can obtain a "superconsistent" estimate of the cointegrating parameters that will be robust to the presence of regressor endogeneity. What is the economic intuition for our results? Investors who want to maintain a flat consumption path over time will attempt to "smooth out" transitory movements in their asset wealth arising from time variation in expected returns. When excess returns are expected to be higher in the future, forward-looking investors will react by increasing consumption out of current asset wealth and labor income, allowing consumption to rise above its common trend with those variables. When excess returns are expected to be lower in the future, these investors will react by decreasing consumption out of current asset wealth and labor income, and consumption will fall below its shared trend with these variables. In this way, investors may insulate future consumption from fluctuations in expected returns, and stationary deviations from the shared trend among consumption, asset holdings, and labor income are likely to be a predictor of excess stock returns, consistent with what we find. 818 The Journal of Finance The rest of the paper is organized as follows. The next section presents the theoretical framework linking consumption, aggregate wealth, and expected returns, and shows how we express the important predictive components of the consumption-aggregate wealth ratio in terms of observable variables. In Section 11, we present the results of estimating the trend relationship among consumption, labor income, and asset holdings. We then move on to test the important implication o