“By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior”
Journal of Political Economy, 107, 205-251 (April 1999) (With John Y. Campbell) JSTOR Manuscript with extra appendices A utility function with a slow-moving habit generates slow-moving countercyclical risk aversion. In turn this generates time-varying price/dividend ratio that forecasts stock returns, does not forecast dividends, and so forth. Balancing intertemporal substitution with precautionary savings gives a constant interest rate, the usual problem with habit models. The NBER working paper version includes a time-varying interest rate, which also generates yield spreads that forecast bond returns.