On the Estimation of the Consumption-Wealth Ratio: Cointegrating Parameter Instability and its Implications for Stock Return Forecasting

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Abstract
This paper investigates if the parameters of the cointegration among consumption, asset wealth, and labor income are stable over the post-war sample period. Although Lettau and Ludvigson (2001a) find that the estimated consumption-wealth ratio (CAY) is a strong predictor of aggregate stock returns, the instability of the cointegrating parameters suggests that the empirical applications of CAY are problematic. Our empirical results from subsample estimations, stability tests, error correction coefficients estimations, and rolling regressions all indicate substantial changes in the cointegrating parameter estimates over the sample period, which translates into the deteriorating forecasting power of CAY for aggregate stock returns.

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