NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Why Surplus Consumption in the Habit Model May be Less Persistent than You Think

Anthony W. Lynch, Oliver Randall

NBER Working Paper No. 16950
Issued in April 2011
NBER Program(s):   AP

In U.S. data, value stocks have higher expected excess returns and higher CAPM alphas than growth stocks. We find the external-habit model of Campbell and Cochrane (1999) can generate a value premium in both CAPM alpha and expected excess return so long as the persistence of the log surplus-consumption ratio is not too high. In contrast, Lettau and Wachter (2007) find that when the log surplus-consumption ratio is assumed to be highly persistent as in Campbell and Cochrane, the external-habit model generates a growth premium in expected excess return. However, the micro evidence favors a less persistent log surplus-consumption ratio. We choose a value for this persistence which is sufficiently low that the most recent 2 years of log consumption contribute over 98% of all past consumption to log habit, which is a much more reasonable number than the 25% contribution generated by the Lettau-Wachter value. In our model, expected consumption is slowly mean-reverting, as in the long-run risk model of Bansal and Yaron (2004), which is why our model is able to generate a price-dividend ratio for aggregate equity that exhibits the high autocorrelation found in the data, despite the very low persistence of the price-of-risk state variable. Our results suggest that an external habit model in the spirit of Campbell and Cochrane can deliver an empirically sensible value premium once the persistence of the surplus consumption ratio is calibrated to the micro evidence rather than set to a value close to one. When we allow the conditional volatility of consumption growth to also be slowly mean reverting as in the long-run risk model of Bansal and Yaron, our model is also able to generate empirically sensible predictability of long-horizon returns using the price-dividend ratio, without eroding the value premium. Our results also suggest that models with fast-moving habit can deliver several empirical properties of aggregate dividend strips that have been recently documented.

download in pdf format
   (552 K)

email paper

This paper is available as PDF (552 K) or via email.

This paper was revised on December 5, 2011

Machine-readable bibliographic record - MARC, RIS, BibTeX

Document Object Identifier (DOI): 10.3386/w16950

Users who downloaded this paper also downloaded these:
Leeper, Walker, and Yang w16951 Foresight and Information Flows
Ball and Mazumder w17044 Inflation Dynamics and the Great Recession
Snowberg, Wolfers, and Zitzewitz w16949 How Prediction Markets Can Save Event Studies
Bonaparte, Cooper, and Zhu w16957 Consumption Smoothing and Portfolio Rebalancing: The Effects of Adjustment Costs
Brunnermeier, Nagel, and Pedersen w14473 Carry Trades and Currency Crashes
 
Publications
Activities
Meetings
NBER Videos
Data
People
About

Support
National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138; 617-868-3900; email: info@nber.org

Contact Us