Aggregate Consumption-Wealth Ratio and the Cross-Section of Stock Returns: Some International Evidence

By Paul Gao and Kevin X.D. Huang
August 2004; Last Revised December 2004 
RWP 04-07
Research Division 
Federal Reserve Bank of Kansas City 

Abstract

      We find that the short-term deviations from long-run consumption-wealth relationship (cay) forecast stock market returns and serve as a conditioning variable in the capital asset pricing model (CAPM) for explaining the cross-section of stock returns for the United Kingdom and Japan. Our cross-sectional regressions using cay as a conditioning variable as opposed to using an alternative variable, tay, constructed using calendar time in place of consumption indicate that it is unlikely to be a spurious variable and provides useful information concerning the economic fundamentals. We show that both a consumption-based capital asset pricing model (CCAPM) and a human-capital-augmented capital asset pricing model (HC-CAPM) in conjunction with this conditioning variable can explain much of the cross-section of stock returns in each of the two countries; yet, in terms of relative performance, our results tend to favor the conditional HC-CAPM over the conditional CCAPM for pricing U.K. and Japanese cross-sectional returns.

Keywords: Asset Pricing Models, Conditional Asset Pricing Models, CAY

JEL Codes: E21; G12; G14

Paul P.J. Gao is a doctoral student at the Kellogg School of Management of the Northwestern University and Kevin X.D. Huang is an economic advisor and economist at the Federal Reserve Bank of Philadelphia. Much of this paper was written while Paul was visiting the Federal Reserve Bank of Kansas City and Kevin was a senior economist with the Federal Reserve Bank of Kansas City. The authors wish to thank Torben Andersen, Todd Clark, Kent Daniel, Ravi Jagannathan, Sydney Ludvigson, Yong Wang, and seminar participants at the Federal Reserve Bank of Kansas City for helpful discussions and comments. The authors are grateful to Carol Bertaut, Kent Daniel, Stefan Nagel, and many other researchers who have shared with us their data. The views expressed herein are solely those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Kansas City, Philadelphia, or the Federal Reserve System.

Gao email:  p-gao@kellogg.northwestern.edu
Huang email:  kevin.huang@phil.frb.org

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