Predictability and habit persistence

Abstract

This paper highlights the role of persistence in explaining predictability of excess returns. To this end, we develop a CCAPM model with habit formation when the growth rate of endowments follows a first order Gaussian autoregression. We provide a closed form solution of the price–dividend ratio and determine conditions that guarantee the existence of a bounded equilibrium. The habit stock model is found to possess internal propagation mechanisms that increase persistence. It outperforms the time separable and a ‘Catching up with the Joneses’ version of the model in terms of predictability therefore highlighting the role of persistence in explaining the puzzle.