Non-linear external habit persistence models, which feature prominently in the recent "equity premium" asset pricing and macroeconomics literature, generate counterfactual predictions in the cross section of stock returns. In particular, we show that in the absence of cross sectional heterogeneity in firms' cash flow risk these models produce a "growth premium," that is, stocks with high price-to-fundamental ratios command a higher premium than stocks with low price-to-fundamental ratios. This implication is at odds with the well established empirical observation of a "value premium" in the cross section of stock returns. Substantial heterogeneity in firms' cash flow risk yields both a value premium as well as most of the stylized facts about the cross-section of stock returns, but it generates a "cash flow risk puzzle": Quantitatively, value stocks have to have "too much" cash flow risk compared to the data to generate empirically plausible value premia.
The PDF above is a preprint version of the article. The final version may be found at < http://dx.doi.org/10.1016/j.jfineco.2010.05.003 >.