The Long and the Short of Asset Prices: Using Long Run Consumption-Return Correlations to Test Asset Pricing Models∗

This paper examines a new set of implications of existing asset pricing models for the correlation between returns and consumption growth over the short and the long run. The findings suggest that external habit formation models face a challenge in producing two robust facts in aggregate data, namely, that stock market returns lead consumption growth, and that the correlation between returns and consumption growth is higher at low frequencies than it is at high frequencies. To reconcile these facts with a consumption-based model, I show that one needs to focus on models that contain a ”forward looking” consumption component, i.e., models that allow for both trend and cyclical fluctuations in consumption, and that link expected returns to the cyclical fluctuations in consumption. The models by Bansal and Yaron (2004) and Panageas and Yu (2005) provide examples of such models. ∗This paper is based on the third chapter of my Ph.D. dissertation submitted to the University of Pennsylvania. I would like to thank my dissertation committee members, Andy Abel, Stavros Panageas, and Amir Yaron for encouragement and detailed comments. I have also benefited from comments by Santiago Bazdresch, Frederico Belo, Wilson Wonho Choi, Itamar Drechsler, Joao Gomes, Jeremy Graveline, Urban Jermann, Dana Kiku, Nikolai Roussanov, Robert Stambaugh, Skander Van den Heuvel, Yu Yuan, Paul Zurek, and seminar participants at the Wharton School, the University of Minnesota, Baruch of CUNY, the University of Iowa, Lehman Brothers, and the 2008 NASM of the Econometric Society at Pittsburgh. Of course any errors are mine own. †Department of Finance, 3-133 Carlson School of Management, 321 19th Avenue South, Minneapolis, MN 55455. Email: [email protected], mobile: 215-796-8442.