The NBER's Program on Asset Pricing met in Cambridge on November 3. Pietro Veronesi, University of Chicago Campbell , Chan , and Viceira show how the predictability of asset returns can affect the portfolio choices of long-lived investors who value wealth not for its own sake but for the consumption it can support. Their empirical estimates, based on long-run annual and postwar quarterly U.S. data, suggest that the predictability of stock returns greatly increases the optimal demand for stocks.
Nominal bonds have only a small role in optimal long-term portfolios.
These two firm characteristics appear to predict stock returns because they are correlated with the true conditional market beta of returns. These cross-sectional relations can subsist even after controlling for a typical empirical estimate of market beta. Dai develops a general equilibrium model for a representative agent production economy with stochastic internal habit formation. Dai describes has a scale-independent economy with a unique stochastic investment opportunity set. Local correlation between the stochastic interest rate and the time-varying market price of risk can be determined endogenously and leads to correct predictions of the sign and magnitude of several major empirical puzzles in both equity and bond markets.