Predictability in Consumption Growth and Equity Returns : A Bayesian Investigation

We estimate a widely cited consumption-based asset pricing model using fully Bayesian MCMC method. Although the model is generally consistent with consumption and dividend growth moments in annual data, the conditional mean of consumption growth (a latent process) is not persistent enough to satisfy the model's restriction that the price/dividend ratio be an affine function of the latent process. We argue that this lack of persistence in the latent process may result in equity volatility puzzle. The model accounts for only 50% of total variation in asset returns. The model can explain equity premium at a cost of high risk aversion. We also find that a one-factor nature of the model implies zero predictability of excess equity returns by price/dividend ratios