Macroeconomic Risk and the Cross-Section of Stock Returns

We develop a conditional version of the consumption CAPM using the conditioning variable from the cointegrating relation among macroeconomic variables (dividend yield, term spread, default spread, and short-term interest rate). Our conditioning variable has a strong power to predict market excess returns in the presence of the competing predictive variables. In addition, our conditional consumption CAPM performs about as well as the Fama and French (1993) three-factor model in explaining the cross-section of the Fama and French 25 size and book-to-market sorted portfolios. Our specification shows that value stocks are riskier than growth stocks in bad times supporting the risk-based story