Consumer expectations and short-horizon return predictability

Lettau and Ludvigson [Lettau, M., Ludvigson, S, 2001. Consumption, aggregate wealth and expected stock returns. Journal of Finance 56, 815849] argue that fluctuations from the equilibrium ratio of consumption to wealth (cy) reflect changing expectations of asset returns and document significant short-horizon predictability based on cy. This paper further explores the role of consumer expectations in modeling time variation of expected equity returns by considering two measures of consumer expectations: (i) consumer behavior as reflected in cy, and (ii) a more-direct measure of expectations captured by the Index of Consumer Sentiment (ICS). We report strong regression-based evidence of return predictability based on cy, which remains evident even after accounting for various sources of estimation risk. However, the regression-based evidence of predictability does not necessarily imply that shifts in aggregate consumption and the components of aggregate wealth give rise to economically significant investment signals. The survey-based measure of expectations (ICS) is shown to complement the behavioral measure (cy) but has no apparent stand-alone predictive value in forecasting equity returns.