Expected returns and the business cycle: heterogeneous agents and heterogeneous goods

Lochstoer, L (2006) Expected returns and the business cycle: heterogeneous agents and heterogeneous goods. Working Paper. London Business School IFA Working Paper.

Abstract

I document that the expected excess stock market returns contain both lowfrequency and higherfrequency components. The lowfrequency variation is associated with pricerelated variables such as the divided/price ratio, while the higherfrequency variation is associated with business cycle variables such as GDP growth. The two components interact. In particular, when the lowfrequency component of the equity premium is high, the impact of the business cycle fluctuations on the equity premium is stronger. I propose a simple explanation: fundamental risks in the economy fluctuate at a business cycle frequency, while the risk tolerance of the marginal investor varies at a lower, "generational" frequency. I construct a general equilibrium model with heterogeneous agents and heterogeneous goods that can account for the new empirical findings. The equilibrium interaction of the dynamic allocation of wealth across agents and of consumption across goods give rise to the empirical relation between the lowfrequency price variables, the higherfrequency businesscycle variables, and future excess stock market returns.