A Consumption-Based Explanation of Expected Stock Returns

Abstract

When utility is non-separable in nondurable and durable consumption and the elasticity of substitution between the goods is high, marginal utility rises when durable consumption falls. The model explains both the cross-sectional variation in expected stock returns and the time variation in the equity premium. Small stocks and value stocks deliver relatively low returns during recessions when durable consumption falls, which explains their high average returns relative to big stocks and growth stocks. Stock returns are unexpectedly low at business-cycle troughs when durable consumption falls sharply, which explains the counter-cyclical variation in the equity premium.

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