Explaining the poor performance of consumption-based asset pricing models

We show that the external habit-formation model economy of Campbell and Coc hrane (1999) can explain why the Capital Asset Pricing Model (CAPM) and its extensions are better approximate asset pricing models than is the standar d consumption-based model. The model economy produces time-varying expected returns, tracked by the dividend-price ratio. Portfolio-based models captu re some of this variation in state variables, which a state-independent fun ction of consumption cannot capture. Therefore, though the consumption-base d model and CAPM are both perfect conditional asset pricing models, the por tfolio-based models are better approximate unconditional asset pricing mode ls.