Working Paper: CEPR ID: DP2223
Authors: Martin Lettau; Sydney Ludvigson
Abstract: This paper studies the role of detrended wealth in predicting stock returns. We call a transitory movement in wealth one that produces a deviation from its shared trend with consumption and labor income. Using quarterly stock market data we find that these trend deviations in wealth 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 earnings yield, the dividend payout ratio and several other popular forecasting variables. Why should wealth, detrended in this way, forecast asset returns? We show that a wide class of optimal models of consumer behavior imply that the log consumption-aggregate (human and nonhuman) wealth ratio forecasts the expected return on aggregate wealth, or the market portfolio. Although this ratio is not observable, we demonstrate that its important predictive components may be expressed in terms of observable variables, namely in terms of consumption, nonhuman wealth 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.
Keywords: stock returns; consumption; wealth; human capital; forecasting; cointegration
JEL Codes: E21; G10
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| detrended wealth (D31) | stock returns (G12) |
| log consumption-aggregate wealth ratio (E25) | expected returns on the market portfolio (G17) |
| consumption, nonhuman wealth, labor income (E21) | expected returns on the market portfolio (G17) |