Contrarian flows, consumption and expected stock returns

Abstract

We investigate the relation between contrarian flows, consumption growth, and market risk premium. We construct a contrarian flows measure by summing up the capital flows to stocks that go against the total flow of the aggregate market. We show that the contrarian flows are negatively influenced by the same-quarter consumption growth. During bad times, the majority of investors who are affected by the negative shock reduce their equity exposure, and these extra supplies of risky assets are absorbed by contrarian investors who are least affected by the consumption shock. Using quarterly stock market data, we find that the contrarian flows forecast market returns at short-to-intermediate horizons. The predictability stems from the component that is explained by the consumption growth, and therefore the consumption growth contains valuable information about the market risk premium. Moreover, the predictability is stronger for growth stocks than for value stocks, and hence it negatively predicts the value premium. This is because the contrarian flows measure the market risk premium and growth stocks bear more discount rate risk than value stocks. Out-of-sample tests show that the main results are robust to data-snooping bias.