Alessandro Melone (Vienna Graduate School of Finance) (Webinar)

“Consumption Disconnect Redux”

Abstract.  According to the permanent income logic, individuals form expectations about their ability to produce in the long run and decide how much to consume today according to their forecasts. This paper documents that deviations of current consumption from its permanent level warranted by productivity—termed the consumption gap—comove with survey measures of consumer sentiment and forecast stock returns in- and out-of-sample, subsuming other well-known consumption-based predictors. Using the consumption gap to time the market, a mean-variance investor would achieve an annualized average certainty equivalent return of 2.39%. In the cross-section of stocks, the consumption gap relates to the time-varying coefficients of a conditional CAPM, suggesting that temporary consumption fluctuations track the price of market risk. This result leads to an empirical stochastic discount factor that displays properties comparable to theoretical counterparts in benchmark macro-finance models.