Habit formation, surplus consumption and return predictability: International evidence

• Published in: Journal of international money and finance Vol. 29; no. 7; pp. 1237 - 1255
• Main Authors: Engsted, Tom, Hyde, Stuart, Møller, Stig V.
• Format: Journal Article
• Language: English
• Published: Kidlington Elsevier Ltd 01-11-2010; Elsevier; Elsevier Science Ltd
• Series: Journal of International Money and Finance
• Subjects: Bond markets; Bonds; Campbell–Cochrane model; Consumption; Economic models; Economic theory; Expected returns; Generalized method of moments; GMM estimation; Habit formation; Habit formation Campbell-Cochrane model Surplus consumption ratio GMM estimation Pricing errors Return predictability; International economic relations; Investment returns; Political economy; Pricing errors; Return predictability; Risk assessment; Stock prices; Stock returns; Studies; Surplus consumption ratio; Surplus consumption ratio; Return predictability; E21; Pricing errors; GMM estimation; G12; G15; Habit formation; Campbell–Cochrane model
• ISSN: 0261-5606; 1873-0639
• DOI: 10.1016/j.jimonfin.2010.03.004

On an international post World War II dataset, we use an iterated GMM procedure to estimate and test the Campbell and Cochrane (1999, By force of habit: a consumption-based explanation of aggregate stock market behavior. Journal of Political Economy 107, 205–251.) habit formation model with a time-varying risk-free rate. In addition, we analyze the predictive power of the surplus consumption ratio for future stock and bond returns. We find that, although there are important cross-country differences and economically significant pricing errors, for the majority of countries in our sample the model gets empirical support in a variety of different dimensions, including reasonable estimates of risk-free rates. Further, for the majority of countries the surplus consumption ratio captures time-variation in expected returns. Together with the price-dividend ratio, the surplus consumption ratio contains significant information about future stock returns, also during the 1990s. In addition, in most countries the surplus consumption ratio is also a powerful predictor of future bond returns. Thus, the surplus consumption ratio captures time-varying expected returns in both stock and bond markets.