Procyclicality of the Comovement between Dividend Growth and Consumption Growth

I document that dividend growth and consumption growth comove procyclically. This new stylized fact empirically resolves the “Duffee Puzzle”—stock returns and consumption growth covary procyclically (Duffee, 2005)—but contradicts extant theoretical assumptions in asset pricing models. I then design a new data generating process (DGP) for the joint consumption-dividend dynamics which fits the procyclical comovement and a wide set of other related second moments. Lastly, I solve a variant of Campbell and Cochrane’s habit formation model with this new DGP and the procyclical consumption-dividend growth comovement as a new state variable. The new procyclical component in the amount of risk induces a more volatile price-dividend ratio at the cost of a lower equity premium due to the now counterbalancing dynamics of the price (countercyclical) and amount (procyclical) of risk. In addition, the new state variable accounts for 13% of the variability of the price dividend ratio in the data and carries a positive price of risk in the cross-section of stock returns.