The Asset Pricing-Macro Nexus and Return-Cash Flow Predictability

Abstract

In this paper we develop a measure of aggregate dividends (net payout) and a corresponding valuation ratio that incorporate the economic restrictions that all outstanding equity should be held by investors. Using this market clearing based aggregate measure of payouts changes the traditional views on the sources of asset price variation; with the aggregate dividend measure, a lot of the asset price variation is due to predictability of payout growth. In addition, the new aggregate payout measure is naturally cointegrated with aggregate consumption. We develop a long-run risks based economic model that incorporates this restriction. We show that the model can account for the return and payout growth predictability needed to explain the asset price variation in conjunction with the risk premium and volatility puzzles.