External Habit and the Cyclicity of Expected Stock Returns

Thomas Tallarini and Harold Zhang
Graduate School of Industrial Administration, Carnegie Mellon University
huibingz@pareto.gsia.cmu.edu

Abstract

This paper extends the Campbell and Cochrane (1994) study by focusing on the cyclical behavior of the expected stock returns implied in an economy with an external habit. Using numerical solution methods, we find that the cyclicality of expected stock returns implied by the economic model is sensitive to how the external habit reacts to the contemporaneous economy wide per capita consumption growth. To pin down the structural parameters, we formally estimate the model using Gallant and Tauchen's Efficient Method of Moment (EMM) approach (1996). The estimated parameters imply countercyclical expected stock returns as documented in Campbell and Cochrane. The model, however, is still rejected at the 5% level. Detailed examination of the moment conditions in our estimation indicates that the model performs reasonably well in matching the mean of the stock returns, but it fails to capture the variance and higher order moments.

...moments.

The most recent version of this paper is available as a postscript file, ehabit.ps, by anonymous ftp to pareto.gsia.cmu.edu, subdirectory pub/papers.