Understanding the empirical linkages between macroeconomic variables and financial markets has long been a goal of financial economics. One reason for the interest in these links is that stock returns appear to vary with the business cycle. This evidence suggests that stock returns should be forecastable by business cycle variables at cyclical frequencies. Yet the most successful variables at predicting stock market fluctuations are not macroeconomic variables but financial variables: dividend-price ratios, earnings-price ratios and dividend-earnings ratios are all able to predict stock returns over long-term horizons. Over shorter horizons, spanning the length of a typical business cycle, stock returns have typically been found to be only weakly forecastable. Traditional macroeconomic variables have proven especially feeble predictors of stock returns over any time span.

A CEPR Discussion Paper by Martin Lettau and Sydney Ludvigson adopts a new approach to investigating the links between macroeconomics and financial markets. The paper studies the role of transitory movements in aggregate household wealth for predicting stock market fluctuations, arguing that these movements can predict stock returns over horizons as short as one quarter. Aggregate household wealth is defined as the sum of both human (i.e. human capital) and non-human (i.e. asset holdings) wealth. The authors begin by noting that aggregate consumption, asset holdings and labour income share a common long-term trend but may deviate substantially from one another in the short run. Their results show that these 'trend deviations' are a strong univariate predictor of both raw stock returns and excess stock returns over a Treasury-bill rate, and can account for a substantial fraction of the variation in future returns.

This 'trend deviation' variable, a proxy for the log consumption-wealth ratio, provides information about future stock returns that is not captured by lagged values of other variables which are popular among forecasters. Trend deviations display their greatest predictive powers for returns over business cycle frequencies - i.e. those ranging from one to five quarters. In addition, Lettau and Ludvigson find that this variable would have improved out-of-sample forecasts of excess stock returns in post-war data relative to a variety of alternative forecasting models. These results occur despite the fact that the individual growth rates of consumption, labour income, and asset wealth, like other macroeconomic variables, bear little relationship to future stock returns.

So why does household wealth, de-trended in this way, help predict asset returns? In the empirical macroeconomic literature, consumption behaviour has traditionally been studied using models that assume expected asset returns are constant over time, as in the permanent income framework of Hall (1978) and Flavin (1981). These models rule out any link between real consumption and movements in asset returns that can be forecasted. Lettau and Ludvigson develop a broader theoretical framework that generalizes the simple permanent income model, by allowing for time-varying expected returns. Their framework is able to encompass a number of different models of investor behaviour where consumption is a function of aggregate wealth - defined as the sum of human capital and asset wealth. For a wide range of preferences, the log of the ratio of consumption to aggregate wealth predicts asset returns because it is a function of expected future returns from total wealth. This result has been noted previously by Campbell and Mankiw and is the starting point of the theoretical framework.

There are two important practical obstacles that must be overcome before the log consumption aggregate-wealth ratio can be empirically linked with future asset returns. The most immediate is that aggregate wealth, specifically the human capital part of it, is unobservable. The authors argue that the important predictive components of the consumption aggregate-wealth ratio for future market returns may be expressed in terms of observable variables, namely in terms of consumption, asset holdings and current labour income. And they assume that aggregate labour income may be described by the product of a stationary 'return' multiplied by the aggregate stock of human capital, implying that the non-stationary component of human capital may be captured by labour income itself. Consequently, the unobservable log consumption aggregate-wealth ratio may be expressed as the difference between log consumption and a weighted average of log labour income and log asset wealth. The weights on log labour income and log asset wealth are the average ratios of human and non-human wealth in aggregate wealth, respectively. In practice, this results in coefficients of about one-third for asset wealth and two-thirds for human capital.

Hence the authors' model implies that the log of consumption, labour income and asset holdings are co-integrated. If expected consumption growth is not too volatile, stationary deviations from this shared trend produce movements in the consumption aggregate-wealth ratio which can predict future asset returns. This follows from the fact that the consumption aggregate-wealth ratio summarizes agents' expectations of future returns to aggregate wealth. Accordingly, deviations from the shared trend will forecast returns to asset holdings, as long as the expected return to human capital is not too volatile.

The economic intuition for this result can be described as follows. Investors who want to maintain a flat consumption path over time will attempt to 'smooth out' transitory movements in their asset wealth arising from time-variation in expected returns. When excess returns are expected to be higher in the future, forward-looking investors will react by increasing consumption out of current asset wealth and labour income, allowing consumption to rise above its common trend with those variables. When excess returns are expected to be lower in the future, these investors will react by decreasing consumption out of current asset wealth and labour income, and consumption will fall below its shared trend with these variables. In this way, investors may insulate future consumption from fluctuations in expected returns, and stationary deviations from the shared trend are likely to be a predictor of excess stock returns.

Lettau and Ludvigson test their model's predictions using quarterly US per capita data for consumption, household net worth and net labour income over the period 1952-98. They regress consumption on household net worth and net labour income, and use the residuals from this regression as their 'trend deviation' variable. Their financial data include stock returns, dividends per share and quarterly earnings per share from the Standard and Poor's (S&P) Composite index. Plotting the trend deviations and the excess returns on the S&P Composite index shows a multitude of episodes in which positive trend deviations precede large positive excess returns and negative ones precede large negative returns. This pattern is evident during the 1950s and early 1960s, when the deviations shot up prior to a sequence of 'up ticks' in excess returns, during the 1970s, when sharp declines in the deviations led the bear markets of those years, and during the 1980s, when the trend deviation turned negative prior to the 1987 stock market crash.

Combining the trend deviation variable with variables on the log dividend-price ratio and the log dividend-earnings ratio reveals a substantial forecastibility of stock returns at both short-run and long-run horizons. The authors run a number of forecasting regressions, all of which are significantly improved by the inclusion of a one-quarter lag of the trend deviation variable. For example, a regression of the excess returns on the S&P Composite index on its own one quarter lag has little explanatory power, but adding de-trended wealth allows the regression to predict an extra 9% of the variation in the next quarter’s excess return.

An important policy implication of these results is that large swings in financial assets need not be associated with large subsequent movements in consumption. Currently, this issue is one of pressing importance as fears rise that substantial declines in US equity markets will cause consumer spending to decrease sharply. Lettau and Ludvigson's model suggests that the real economy may be less vulnerable to transitory movements in asset values than many analysts presume: with consumption well below its traditional ratio to asset wealth and labour income, the model implies that households in the US have already factored the expectation of lower returns into today's consumption and will therefore not need to make large adjustments tomorrow.