Explaining the Poor Performance of Consumption-based Asset Pricing Models

We show that the external habit-formation model economy of Campbell and Cochrane ~1999! can explain why the Capital Asset Pricing Model ~CAPM! and its extensions are better approximate asset pricing models than is the standard consumptionbased model. The model economy produces time-varying expected returns, tracked by the dividend–price ratio. Portfolio-based models capture some of this variation in state variables, which a state-independent function of consumption cannot capture. Therefore, though the consumption-based model and CAPM are both perfect conditional asset pricing models, the portfolio-based models are better approximate unconditional asset pricing models. THE DEVELOPMENT OF CONSUMPTION-BASED ASSET PRICING THEORY ranks as one of the major advances in financial economics during the last two decades. The classic papers of Lucas ~1978!, Breeden ~1979!, Grossman and Shiller ~1981!, and Hansen and Singleton ~1982, 1983! show how a simple relation between consumption and asset returns captures the implications of complex dynamic intertemporal multifactor asset pricing models. Unfortunately, consumption-based asset pricing models prove disappointing empirically. Hansen and Singleton ~1982, 1983! formulate a canonical consumption-based model in which a representative investor has timeseparable power utility of consumption. They reject the model on U.S. data, finding that it can not simultaneously explain the time-variation of interest rates and the cross-sectional pattern of average returns on stocks and bonds. Wheatley ~1988! rejects the model on international data. All models can be rejected, and the more important issue is which approximate models are most useful. Alas, the canonical consumption-based model performs no better, and in many respects worse, than even the simple static Capital Asset Pricing Model ~CAPM!. Mankiw and Shapiro ~1986! regress the average returns of the 464 NYSE stocks that were continuously traded from 1959 to 1982 on their market betas, on consumption growth betas, and on both betas. They find that market betas are more strongly and robustly * Campbell is from Harvard University and NBER. Cochrane is from the University of Chicago, Federal Reserve Bank of Chicago and NBER. Campbell’s research is supported by the National Science Foundation via a grant administered by the NBER. Cochrane’s research is supported by the National Science Foundation via a grant administered by the NBER and by the Graduate School of Business. We thank Andrea Eisfeldt, Andrew Abel, George Constantinides, Lars Hansen, John Heaton, Robert Lucas, and an anonymous referee for helpful comments. THE JOURNAL OF FINANCE • VOL. LV, NO. 6 • DEC. 2000