Using long-run consumption-return correlations to test asset pricing models

This paper examines a new set of implications for existing asset pricing models regarding the correlation between returns and consumption growth over both the short run and the long run. The findings suggest that external habit formation models face a challenge in producing two robust facts in aggregate data, namely, that stock market returns lead consumption growth, and that the correlation between returns and consumption growth is higher at low frequencies. To reconcile these facts with a consumption-based model, I demonstrate the need for focusing on models that contain a forward-looking consumption component, i.e., models that allow for both trend and cyclical fluctuations in consumption, and that link returns to cyclical fluctuations in consumption. Long-run risk models provide examples of models that contain this consumption component.

► Asset returns lead consumption and long-run consumption-return correlations are higher. ► The external habit formation model faces a challenge in producing the above two robust facts. ► Models featuring a cyclical component in consumption can match the two stylized facts.