Production-Based Asset Pricing and the Link Between Stock Returns and Economic Fluctuations

This paper describes a production-based asset pricing model. It is analogous to the standard consumption-based model, but it uses producers and production functions in the place of consumers and utility functions. The model ties stock returns to investment returns (marginal rates of transformation) which are inferred from investment data via a production function. The production-based model is used to examine forecasts of stock returns by business-cycle related variables and the association of stock returns with subsequent economic activity. THIS PAPER DESCRIBES A production-based asset pricing model. It is analogous to the standard consumption-based model, but it uses producers and production functions in the place of consumers and utility functions. The production-based model is used to explain two links between stock returns and economic fluctuations that have been the focus of much recent empirical research in finance. These are: 1) a number of variables forecast stock returns, including the term premium, the default premium, lagged returns, dividend-price ratios, and investment; and 2) many of the same variables, and stock returns in particular, forecast measures of economic activity such as investment and GNP growth.1 Since the production-based model is explicitly analogous to the consumption-based model, I start with a review of that model's logic. The consumption-based model ties asset returns to marginal rates of substitution which are inferred from consumption data (or state variables presumed to drive consumption) through a utility function. It is derived from the consumer's first order conditions for optimal intertemporal consumption demand. Its *Department of Economics, University of Chicago. I received many helpful comments in the course of this research. In particular, I thank Andrew Abel, Phillip Braun, Ron Balvers, Robert Chirinko, Gene Fama, Campbell Harvey, Lars Hansen, Robert Hodrick, Bruce Lehmann, George McCandless, Ed Prescott, Gopalakrishnan Sharathchandra, Rene Stulz (the editor) and anonymous referees. This research was partially supported by National Science Foundation grant number SES 88-09912. 1References include the following. Forecasts of stock returns based on lagged returns: Fama and French (1988a), Lo and MacKinlay (1988), Poterba and Summers (1988); based on other variables: Cochrane and Sbordone (1988), Fama (1990a), Fama and French (1988b); quantity variable forecasts based on term premia: Estrella and Hardouvelis (1991), Harvey (1989), Stock and Watson (1989); based on stock returns: Barro (1990), Fama (1981, 1990b), Fama and Gibbons (1982).