Industry bubbles and unexpected consumption shocks: A cross-sectional explanation of stock returns under recursive preferences

Abstract

Assuming an environment with rational and informed agents, where investors exhibit recursive preferences and make their economic decisions embedding industry bubbles into their information sets, we study to what extent unexpected consumption shocks can proxy for revisions in expected consumption growth and, consequently, explain the cross-sectional behavior of stock returns. Our results show that unexpected consumption shocks help forecast future consumption growth, allowing the Epstein-Zin model to satisfactorily explain the equity risk premium of different anomaly portfolios on the Tokyo Stock Exchange. Furthermore, our model provides a better understanding on the dynamics of consumption and its relationship to stock returns.