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A Consumption-Based Explanation of Expected Stock Returns

Motohiro Yogo
The Journal of Finance
Vol. 61, No. 2 (Apr., 2006), pp. 539-580
Published by: Wiley for the American Finance Association
Stable URL: http://www.jstor.org/stable/3699351
Page Count: 42
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A Consumption-Based Explanation of Expected Stock Returns
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Abstract

When utility is nonseparable in nondurable and durable consumption and the elasticity of substitution between the two consumption goods is sufficiently 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 countercyclical variation in the equity premium.

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