Do consumption-based asset pricing models explain return predictability?

This paper studies whether time series predictability is consistent with risk-based asset pricing models. Whereas earlier papers - e.g. Kirby (1998), Cecchetti, et al. (2000) and Avramov (2004) - show that returns are too predictable to be explained by rational asset pricing, we find that the predictability typically found in linear forecasting models is not necessarily larger than can be expected from rational asset pricing. More specifically, when preferences are summarized by habit persistence with habit and risk aversion parameters equal to 0.97 and 4.8 (or greater) respectively, a degree of predictability is obtained that is compatible with the predictability found in the recent literature.