Time Series and Cross-sectional Variations of Expected Returns

Abstract

The paper develops a general equilibrium stochastic growth model of a multi-sector economy subject to i.i.d. taste shocks. Each sector produces one good, and each firm has a linear production technology and faces a quadratic capital adjustment cost. The model contains a standard intertemporal capital asset pricing theory of consumption and portfolio demands with dynamically complete and frictionless markets and a standard q-theory of investment under uncertainty. We show that the equilibrium stochastic investment opportunity set is driven by the relative shares of firms' nominal capital stocks, and the equilibrium dynamics of the state vector is driven by firms' relative investment intensities. Key implications of the model includes (i) the expected equity returns are endogenously predictable both over time and in the cross-section; and (ii) the "value anomaly" arises in a rational expectations equilibrium due to a negative (positive) hedging demand for value (growth) stocks against the risk of cross-sectional dispersion of firms' nominal capital stocks.