By Force of Habit: A Consumption‐Based Explanation of Aggregate Stock Market Behavior

We present a consumption-based model that explains a wide vari- ety of dynamic asset pricing phenomena, including the procyclical variation of stock prices, the long-horizon predictability of excess stock returns, and the countercyclical variation of stock market vol- atility. The model captures much of the history of stock prices from consumption data. It explains the short- and long-run equity pre- mium puzzles despite a low and constant risk-free rate. The results are essentially the same whether we model stocks as a claim to the consumption stream or as a claim to volatile dividends poorly cor- related with consumption. The model is driven by an indepen- dently and identically distributed consumption growth process and adds a slow-moving external habit to the standard power utility function. These features generate slow countercyclical variation in risk premia. The model posits a fundamentally novel description of risk premia: Investors fear stocks primarily because they do poorly in recessions unrelated to the risks of long-run average con- sumption growth.