Finance Research Group Working Papers,
University of Aarhus, Aarhus School of Business, Department of Business Studies

Abstract: This paper finds empirical support for the habit persistence model of Campbell and Cochrane (1999) along both cross-sectional and time-series dimensions of the US stock market over the period 1947-2005. GMM estimations show that the model is able to explain a substantial part of the cross-sectional variation in returns on the 25 Fama and French value and size portfolios, although it has difficulties in fully explaining the value premium. In addition, the model accounts for time-varying expected returns on stocks. The surplus consumption ratio forecasts future stock returns and the forecasting power is not diminished by including the 1990s stock market boom. The extended version of the model allows for cyclical variation in interest rates and provides a reasonable fit of the real risk free rate.

Keywords: Campbell-Cochrane model; 25 Fama-French portfolios; GMM; return predictability by surplus-consumption ratio

31 pages, March 19, 2008

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