Campbell, John Y. and John Cochrane, "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior", Journal of Political Economy, Vol. 107, No. 2, (April 1999), pp. 205-251.

Abstract: We present a consumption-based model that explains a wide variety of dynamic asset pricing phenomena, including the procyclical variation of stock prices, the long-horizon predictability of excess stock returns, and the countercyclical variation of stock market volatility. The model captures much of the history of stock prices from consumption data. It explains the short- and long-run equity premium puzzles despite a low and constant risk-free rate. The results are essentially the same whether we model stocks as a claim to the consumption streams or as a claim to volatile dividends poorly correlated with consumption. The model is driven by an independently and identically distributed consumption growth process and adds a slow-moving external habit to the standard power utility function. These features generate slow countercyclical variation in risk premia. The model posits a fundamentally novel description of risk premia; Investors fear stocks primarily because they do poorly in recessions unrelated to the risks of long-run average consumption growth.

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