Cyclical Consumption as Stock Market Return Predictor

Do investors drive stocks to overvaluation (undervaluation) in good (bad) economic times, such that corresponding expectations for future returns are therefore relatively low (high). In the August 2019 update of their paper entitled “Consumption Fluctuations and Expected Returns”, flagged by a subscriber, Victoria Atanasov, Stig Møller and Richard Priestley introduce the cyclical consumption economic variable and examine its power to predict stock market returns. They hypothesize that in good (bad) economic times:

1. Marginal utility of present consumption is low (high).
2. Investors are willing (unwilling) to sacrifice current consumption for investment.
3. This investment pushes stock prices up (down) and expected returns therefore down (up).

Their principal measure of consumption is quarterly seasonally adjusted real per capita consumption expenditures on non-durables and services from the National Income and Product Accounts (NIPA) Table 7.1 maintained by the U.S. Bureau of Economic Analysis. They extract its cyclical component (detrend) by regressing the logarithm of real per capita consumption on a constant and four lagged values of consumption from about six years prior. They conduct both in-sample and out-of-sample (expanding window regressions, with 2-quarter lag for release delay) tests of the quarterly relationship between cyclical consumption and future U.S. stock market returns. Using the specified consumption data and quarterly returns for the S&P 500 Index and the broad value-weighted U.S. stock market from the first quarter of 1947 through the fourth quarter of 2017, they find that: (more…)