Predicting consumption-wealth ratio changes and stock market returns

We show that the ability of Lettau and Ludvigson's cay ratio to predict stock market returns could be greatly improved when adjustment is made for variations in expected cay ratio changes. We use the present-value identity of Campbell and Mankiw (1989) to derive the appropriate form of the adjustment and model the adjustment using a handful of macroeconomic variables. We find that the expected cay ratio changes vary in a predictable manner. Using our model to adjust cay improves the annual (R) over bar (2) values from 4.42% to 9.55% for in-sample prediction of excess market returns, and the out-of-sample pseudo R-2 values increase from-1.88% and-1.72% to 2.38% and 3.69% with the first estimations using information up to 1985 and 1990, respectively. The superior performance also exists in medium-term market return predictions.