Aggregate Consumption-Wealth Ratio and the Cross-Section of
Stock Returns: Some International Evidence

Paul P.J. Gao

and

Kevin X.D. Huang

We find that the short-term deviations from long-run consumption-wealth relationship (cay) forecast stock market returns and serve as a conditioning variable in the capital asset pricing model (CAPM) for explaining the cross-section of stock returns for the United Kingdom and Japan. Our cross-sectional regressions using cay as a conditioning variable as opposed to using an alternative variable, tay, constructed using calendar time in place of consumption indicate that it is unlikely to be a spurious variable and provides useful information concerning the economic fundamentals. We show that both a consumption-based capital asset pricing model (CCAPM) and a human-capital-augmented capital asset pricing model (HC-CAPM) in conjunction with this conditioning variable can explain much of the cross-section of stock returns in each of the two countries; yet, in terms of relative performance, our results tend to favor the conditional HC-CAPM over the conditional CCAPM for pricing U.K. and Japanese cross-sectional returns.