The Wealth-Consumption Ratio and the Consumption-Habit Ratio

Abstract

Recent research finds that the ratio of aggregate wealth to consumption emerges as a strong forecaster of stock returns. This article reports that the wealth-consumption ratio remains as a strong predictor of stock returns at the presence of the consumption-habit ratio. Most of the variability of the wealth-consumption ratio is not related to the movements of the lagged, contemporaneous, or leading consumption-habit ratios. The results reject the hypothesis that the predictability of the wealth-consumption ratio for stock returns is explained by the consumption-based model with consumption in surplus of habit as a single state variable in favor of a more general model where the moments of consumption growth are determined by at least one state variable imperfectly correlated with consumption in surplus of habit.

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