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I present a consumption-based asset pricing model that is capable of matching the empirically observed Sharpe ratios of the aggregate market portfolio as well as the Fama-French value-minusgrowth portfolio. The model also matches the level of the risk-free rate and the equity premium with a plausible aversion to wealth bets. In empirical analysis, the model performs well in explaining the cross section of average returns of the 25 Fama-French portfolios. The model features a novel non-diversifiable macroeconomic source of risk: the distortion of the variety of the consumption portfolio. In the model, investors derive utility from two consumption goods -nondurables and durables -which are perfect complements. The novel consumption risk of the stock market stems from the inability to sell durables in recessions in order to restore the optimal variety of the consumption basket. * Office of Doctoral Studies, Graduate School of Business, University of Chicago. I have benefitted from helpful comments of

Rietz (1988) and Barro (2006) subject consumption and dividends to rare disasters in the growth rate. We extend their framework and subject consumption and dividends to rare disasters in the growth persistence. We model growth persistence by means of two hidden types of economic slowdowns: recessions and lost decades.We estimate the model based on the post-war U.S. data using maximum likelihood and find that it can simultaneously match a wide array of dynamic pricing phenomena in the equity and bond markets. The key intuition for our results stems from the inability to discriminate between the short and the long recessions ex ante.

An extensive literature has analyzed the implications of hidden shifts in the dividend growth rate. However, corresponding research on learning about growth persistence is completely lacking. Hidden persistence is a novel way to introduce long-run risk into standard business-cycle models of asset prices because it tightly intertwines the cyclical and long-run frequencies. Hidden persistence magnifies endogenous changes in the forecast variance of the long-run dividend growth rate despite homoscedastic consumption innovations. Not only does changing forecast variance make discrimination between protracted spells of anemic growth and brief business recessions difficult, it also endogenously induces additional variation in asset price discounts due to the preference for early uncertainty resolution.