Permanent and Transitory Factors in Intertemporal Asset Pricing

In the Merton (1973) model, expected returns are affected by the market factor plus one or more factors summarizing future investment opportunities The difficulty in empirical implementation has been to proxy for investment opportunities This paper proposes to decompose market return shocks into permanent and temporary components using the Poterba and Summers (1988) formulation We find theoretically that this yields a two-factor asset pricing model, with the permanent component serving a role similar - to the market factor, and the transitory component representing a Merton factor We obtain estimates of the transitory component from a simple Kalman decomposition of market returns Into permanent and transitory components The model explains mean reversion, momentum, the value and size premia, and the poor performance of the CAPM from an efficient markets perspective The testable implications of the model are confirmed empirically