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Housing, Wealth Composition and Expected Stock Return

This paper considers a consumption-based asset pricing model where housing is explicitly modeled both as an asset and consumption good. As consumption good, housing introduces housing expenditure share as a novel risk factor. As an asset, it is the major component of wealth with financial asset. The fluctuation of aggregate housing-financial wealth ratio, as a consequence of irrational housing market, impacts the budget constraints of households. It increases household's exposure to risk and shifts the conditional distribution of consumption growth. Using aggregate data for the United States, we find that the fluctuation of housing-financial wealth ratio is a strong predictor for expected stock return. Conditional on this factor, the covariances of returns with aggregate risk factors explain high ratio of the cross-sectional variation in annual size and book-to-market portfolio returns. The micro mechanism of this asset pricing model is also supported by the micro data from subprime crisis.