Asset Pricing with Durable Goods and Nonhomothetic Preferences

I present a consumption-based asset pricing model that is capable of matching the empirically observed Sharpe ratios of the aggregate market portfolio as well as the Fama-French value-minus-growth portfolio. The model also matches the level of the risk-free rate and the equity premium with a plausible aversion to wealth bets. In empirical analysis, the model performs well in explain- ing the cross section of average returns of the 25 Fama-French portfolios. The model features a novel non-diversi¯able macroeconomic source of risk: the distortion of the variety of the consumption portfolio. In the model, investors derive utility from two consumption goods - nondurables and durables - which are perfect complements. The novel consumption risk of the stock market stems from the inability to sell durables in recessions in order to restore the optimal variety of the consumption basket