Consumption, Dividends, and the Cross-Section of Equity Returns

Abstract

A central economic idea is that an asset's risk premium is determined by its ability to insure against fluctuations in consumption (i.e., by the consumption beta). Cross-sectional differences in consumption betas mirror differences in the exposure of the asset's dividends to aggregate consumption, an implication of many general equilibrium models. Hence, cross-sectional differences in the exposure of dividends to consumption may provide valuable information regarding the cross-sectional dispersion in risk premia. We measure the exposure of dividends to consumption (labeled as consumption leverage) by the covariance of ex-post dividend growth rates with the expected consumption growth rate, and alternatively by relying on stochastic cointegration between dividends and consumption. Cross-sectional differences in this consumption leverage parameter can explain about 50% of the variation in risk premia across 30 portfolios - which include 10 momentum, 10 size, and 10 book-to-market sorted portfolios. The consumption leverage model can justify much of the observed value, momentum, and size risk premium spreads. For this asset menu, alternative models proposed in the literature (including time varying beta models) have considerable difficulty in justifying the cross-sectional dispersion in the risk premia. Our measures of consumption leverage are driven by the exposure of dividend growth rates to low frequency movements in consumption growth. We document that it is this exposure that contains valuable information regarding the cross-sectional differences in risk premia across assets.