A consumption-based explanation of expected stock returns

When utility is nonseparable in nondurable and durable consumption and the elastic-ity of substitution between the two consumption goods is sufficiently high, marginal utility rises when durable consumption falls. The model explains both the cross-sectional variation in expected stock returns and the time variation in the equity pre-mium. Small stocks and value stocks deliver relatively low returns during recessions, when durable consumption falls, which explains their high average returns relative to big stocks and growth stocks. Stock returns are unexpectedly low at business cycle troughs, when durable consumption falls sharply, which explains the countercyclical variation in the equity premium. EXPLAINING THE VARIATION IN EXPECTED RETURNS across stocks and the variation in the equity premium over time as trade-offs between risk and return is a challenge for financial economists. In his review article on market efficiency, Fama (1991, p. 1610) concludes In the end, I think we can hope for a coherent story that (1) relates th