Evaluating Stock Returns with Time-Varying Risk Aversion Driven By Trend Deviations From the Consumption-to-Wealth Ratio: An Analysis Conditional on Income Levels

Document Type

Article

Publication Date

10-5-2007

Publication Title

Review of Financial Economics

Abstract

Based on the cointegrating relationship between consumption and wealth, we estimate the long run consumption‐to‐wealth ratio for each of five consumer income quintiles as well as national data for benchmarking purposes. Short run deviations from the consumption‐to‐wealth ratio for each quintile are examined for their ability to forecast changes in future consumption, income, housing values, and especially stock returns. We demonstrate that these trend deviations when combined with consumption growth in a multifactor model, significantly improve the ability of the dividend‐to‐price ratio to forecast future market returns over short and intermediate horizons for consumers in the highest‐income quintile. This paper contributes to the financial economic literature by showing that the highest‐income consumers are forecasting future stock returns with the help of the persistence in the dividend‐to‐price ratio and are modifying their consumption accordingly.

Comments

© 2008 University of New Orleans

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