Predictability of stock returns and consumption-based CAPM: Evidence from a small open market

Abstract

In this study, we use the conditional consumption CAPM (CCAPM) with the consumption-wealth ratio and/or the surplus consumption ratio to examine the predictability of returns in the Australian equity market. We also explore the relationship between expected excess market returns in Australia and the time-varying risk aversion associated with the world as well as local consumption. Our study reveals that the consumption-wealth ratio can predict the variation of excess stock market returns at the intermediate horizons (from 1 year to 2 years); on the other hand, the surplus consumption ratio can only predict excess stock market returns at the very short horizon, one quarter ahead. We show that these two state variables are not mutually exclusive, but complementary. As a small but open market, Australian market's expected returns should be affected by global price of consumption risk. Our results show that both the world surplus consumption ratio and the world consumption-wealth ratio have predictive power for excess returns in the Australian equity market over the long horizons.