Expected Returns and Habit Persistence

Using a consumption-based asset pricing model with infinite-horizonnonlinear habit formation, Campbell and Cochrane (1999) showthat low consumption in surplus of habit should forecast highexpected returns. This article argues that the finite-horizonlinear habit model also implies an inverse relation betweenexpected returns and surplus consumption. This article alsopresents empirical evidence, which indicates that expected returnson stocks and bonds vary with surplus consumption implied bythe habit models. The volatility of returns and the reward tovolatility are also related to surplus consumption. However,less than 30% of the predictable variation of expected returns,using standard lagged information variables, is attributed tosurplus consumption.