Procyclicality of the comovement between dividend growth and consumption growth |
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| Authors: | Nancy R. Xu |
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| Affiliation: | 1. Rotterdam School of Management, Erasmus University, Department of Finance, Burgemeester Oudlaan 50, P.O. Box 1738, DR Rotterdam 3000, the Netherlands;2. KU Leuven, Faculty of Economics and Business (FEB), Antwerp Carolus Campus, Korte Nieuwstraat 33, Antwerp 2000, Belgium;3. The Liquid House, Aalmoezenierstraat 13, Antwerp 2000, Belgium;1. Harvard Business School, United States;2. Princeton University, United States;1. Lundquist College of Business, University of Oregon, Eugene, OR 97403, United States;2. Department of Business & Information Technology, Missouri S&T, Rolla, MO 65409, United States;1. Carroll School of Management, Boston College, 140 Commonwealth Avenue, Chestnut Hill, MA 02467, USA;2. Swiss Finance Institute at EPFL, Quartier UNIL-Dorigny, Extranef 213, Lausanne CH-1015, Switzerland;3. Carl H. Lindner College of Business, 2906 Woodside Drive, University of Cincinnati, Cincinnati, OH 45221, USA;1. Oslo Metropolitan University, Oslo Business School, Pilestredet 46, Oslo 0130, Norway;2. The Arctic University of Norway, Hansine Hansens veg 18, Tromsø N-9019, Norway;3. Department of Banking and Finance, Monash University, 900 Dandenong Rd., Caulfield East VIC 3145, Australia |
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| Abstract: | Duffee (2005) shows that the amount of consumption risk (i.e., the conditional covariance between market returns and consumption growth) is procyclical. In light of this “Duffee Puzzle,” I empirically demonstrate that the conditional covariance between dividend growth (i.e., the immediate cash flow part of market returns) and consumption growth is (1) procyclical and (2) a consistent source of procyclicality in the puzzle. Moreover, I solve an external habit formation model that incorporates realistic joint dynamics of dividend growth and consumption growth. The procyclical dividend-consumption comovement entails two new procyclical terms in the amount of consumption risk via cash flow and valuation channels, respectively. These two procyclical terms play an important role in generating a realistic magnitude of consumption risk. In contrast to extant habit formation models, the conditional equity premium no longer increases monotonically when a negative consumption shock arrives because it might lower the amount of risk while increasing the price of risk. |
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