Journal
JOURNAL OF BANKING & FINANCE
Volume 31, Issue 10, Pages 3102-3124Publisher
ELSEVIER
DOI: 10.1016/j.jbankfin.2006.11.017
Keywords
return predictability; estimation risk; portfolio choice; consumer expectations; consumption-to-wealth; ratio; cay
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Lettau and Ludvigson [Lettau, M., Ludvigson, S, 2001. Consumption, aggregate wealth and expected stock returns. Journal of Finance 56, 815-849] argue that fluctuations from the equilibrium ratio of consumption to wealth (My) reflect changing expectations of asset returns and document significant short-horizon predictability based on My. This paper further explores the role of consumer expectations in modeling time variation of expected equity returns by considering two measures of consumer expectations: (i) consumer behavior as reflected in My, and (ii) a more-direct measure of expectations captured by the Index of Consumer Sentiment (ICS). We report strong regression-based evidence of return predictability based on My, which remains evident even after accounting for various sources of estimation risk. However, the regression-based evidence of predictability does not necessarily imply that shifts in aggregate consumption and the components of aggregate wealth give rise to economically significant investment signals. The survey-based measure of expectations (ICS) is shown to complement the behavioral measure (cay) but has no apparent stand-alone predictive value in forecasting equity returns. (C) 2007 Elsevier B.V. All rights reserved.
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