The Wealth-Consumption Ratio: A Litmus Test for Consumption-Based Asset Pricing Models

The volatility of the price-dividend ratio on stocks, the predictability of stock returns, and the lack of predictability in dividend growth are commonly interpreted as evidence of substantial time-variation in risk premia. We construct the wealth-consumption ratio for the U.S., the price-dividend ratio on total wealth. We show that it is at least five times less volatile than the price-dividend ratio on stocks. The wealth-consumption ratio encodes information about conditional market prices of risk, and hence about asset prices. Matching its properties is a litmus test for consumption-based asset pricing models. Models that match the predictability of equity returns impute too much predictability to total wealth returns and hence too much volatility to the wealth-consumption ratio, because they rely on time variation in the risk premium on total wealth. The smoothness of the wealth-consumption ratio suggests that there may be less time-variation in market prices of risk than commonly inferred from equity prices alone.