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Time Variation in the Covariance between Stock Returns and Consumption Growth



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    • *Haas School of Business, University of California at Berkeley. Thanks to the many seminar participants who have commented on earlier versions of this paper, and also to an anonymous referee, John Campbell, Karen Dynan, Kris Jacobs, Martin Lettau, and Sydney Ludvigson.


The conditional covariance between aggregate stock returns and aggregate consumption growth varies substantially over time. When stock market wealth is high relative to consumption, both the conditional covariance and correlation are high. This pattern is consistent with the “composition effect,” where agents' consumption growth is more closely tied to stock returns when stock wealth is a larger share of total wealth. This variation can be used to test asset-pricing models in which the price of consumption risk varies. After accounting for variations in this price, the relation between expected excess stock returns and the conditional covariance is negative.