Meeting Macro-Finance Reading Group: Alessandro Melone (VGSF)

Abstract

This paper shows that consumption growth is less informative than consumption levels for conditional asset pricing. I use a permanent-temporary decomposition to identify economic fluctuations in consumption levels which are eliminated by differencing the series. I denote this component as the consumption gap. I find that the consumption gap is the only component of consumption that relates to stock returns and predicts the market portfolio. This fact suggests that the CAPM-SDF varies over the business cycle, with the consumption gap driving time-variation in the SDF coefficients. At the industry level, a dynamic long-short investment strategy that uses the consumption gap to time portfolios market exposures generates a Sharpe Ratio of 0.79. These results provide support for the link between consumption and intertemporal investment opportunities and contribute to the current debate on factor and market timing.

Organizer: Fabio Franceschini