Jy. Campbell et Jh. Cochrane, By force of habit: A consumption-based explanation of aggregate stock market behavior, J POLIT EC, 107(2), 1999, pp. 205-251
We present a consumption-based model that explains a wide variety of dynami
c asset pricing phenomena, including the procyclical variation of stock pri
ces, the long-horizon predictability of excess stock returns, and the count
ercyclical variation of stock market volatility. The model captures much of
the history of stock prices from consumption data. It explains the short-
and long-run equity premium puzzles despite a low and constant risk-free ra
te. The results are essentially the same whether we model stocks as a claim
to the consumption stream or as a claim to volatile dividends poorly corre
lated with consumption. The model is driven by an independently and identic
ally distributed consumption growth process and adds a slow-moving external
habit to the standard power utility function. These features generate slow
countercyclical variation in risk premia. The model posits a fundamentally
novel description of risk premia: Investors fear stocks primarily because
they do poorly in recessions unrelated to the risks of long-run average con
sumption growth.