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Working Paper
Habit, Production, and the Cross-Section of Stock Returns
Solutions to the equity premium puzzle should inform us about the cross-section of stock returns. An external habit model with heterogeneous firms reproduces numerous stylized facts about both the equity premium and the value premium. The equity premium is large, time-varying, and linked with consumption volatility. The cross-section of expected returns is log-linear in B/M, and the slope matches the data. The explanation for the value premium lies in the interaction between the cross-section of cash flows and the time-varying risk premium. Value firms are temporarily low productivity firms, ...