Asset Pricing with Garbage

A new measure of consumption, garbage, is more volatile and more correlated with stocks than the canonical measure, National Income and Product Accounts (NIPA) consumption expenditure. A garbage-based consumption capital asset pricing model matches the U.S. equity premium with relative risk aversion of 17 versus 81 and evades the joint equity premium-risk-free rate puzzle. These results carry through to European data. In a cross-section of size, value, and industry portfolios, garbage growth is priced and drives out NIPA expenditure growth. THE TEXTBOOK STATEMENT of the equity premium puzzle is that under standard assumptions, given the observed low volatility of consumption, the average excess return of stocks over bonds is too high (Mehra and Prescott (1985)). The textbook response is to introduce new preferences (e.g., Epstein and Zin (1991) and Constantinides (1990)), posit incomplete markets (e.g., Constantinides and Duffie (1996)), or conjure rare disasters (e.g., Rietz (1988)). Similarly, the longrun risk literature (e.g., Bansal and Yaron (2004)) relies on both nonstandard preferences and hard-to-detect low-frequency consumption volatility. But a simple restatement of the puzzle hints at a more parsimonious solution: under standard assumptions, given the observed high equity premium, measured consumption is too smooth. A new and distinct measure of consumption could shed light on the puzzle by addressing the key question: is the problem with the model or with the data? In this paper, I use municipal solid waste (MSW), or simply garbage, as a new measure of consumption. Virtually all forms of consumption produce waste, and they do so at the time of consumption. Rates of garbage generation should be informative about rates of consumption. The main sample consists of 47 years of annual data from the U.S. Environmental Protection Agency (EPA). Per capita garbage growth, the ratio of next year’s garbage (in tons) to this year’s garbage, is two and a half times more volatile and one and a half times more highly correlated with stock returns than the standard measure of consumption, personal expenditure on nondurable goods and services from the National Income and Product ∗Savov is with the University of Chicago Booth School of Business. I am especially grateful to John Cochrane and Pietro Veronesi, as well as to Editor Campbell Harvey, and an anonymous referee and associate editor. I thank Shelly Schneider from Franklin Associates for providing the data. I also thank George Constantinides, Douglas Diamond, Robert Dittmar, John Heaton, and participants in the 2008 WFA Annual Meetings and the Chicago Booth Student Brownbag. I received support from the Center for Research in Security Prices. An Internet Appendix is available at http://www.afajof.org/supplements.asp.